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TRADING COMPS MODELI NG
WALL STREET PREP EXA M
QUESTIONS AND ANSWER S
Question 1: Why do we use trading comps to value
companies?
CORRECT ANSWER: The purpose of a trading comps
analysis is to determine what is the "appropriate" value of a company, based on the market values of operationally similar companies. When you try to gauge the fair value of your house by comparing to the values of houses nearby, you're doing a comps analysis.
Question 2: How are comps analyzed?
CORRECT ANSWER: We don't compare absolute
values but rather multiples to account for differences in a company.
Question 3: What are non-operational differences that
should be taken into account so as to not distort the comparison?
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CORRECT ANSWER: Financial leverage differences,
Accounting differences (depreciation method, useful life assumptions), Temporary distortions (nonrecurring items), Other accounting differences (lease classification, LIFO vs. FIFO), Business life cycle differences.
Question 4: What are examples of measures independent
of leverage?
CORRECT ANSWER: EV, Revenue, EBITDA, EBIT,
Unlevered free cash flow.
Question 5: How should nonrecurring items in historical
profits be handled?
CORRECT ANSWER: must be taken out of profits in
order to exclude the distortion.
Question 6: What should be done when companies are in
different stages in their life cycle?
CORRECT ANSWER: Multiples like PEG standardize
against different long-term growth rates. EV/revenue
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facilitate comparisons for early stage companies generating losses.
Question 7: What is the definition and description of the
PE ratio?
CORRECT ANSWER: share price/EPS, Equity
Value/Net income. EPS is used as a proxy for economic equity value.
Question 8: What are the issues with the P/E ratio?
CORRECT ANSWER: EPS is a measure of accounting
profit only during a particular period. Accounting profits can be misleading because they include noncash and nonrecurring items, and accounting assumptions, and can be manipulated. Also, high PE valuation relative to peers could be justified when high PE firm has higher growth prospects. Less relevant for high growth companies.
Question 9: When is EPS most appropriate?
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CORRECT ANSWER: Mature lifecycle companies,
Companies with positive earnings, Companies with similar capital structures.
Question 10: What is the definition and issues with the
PEG ratio?
CORRECT ANSWER: PE ratio / long-term growth rate.
Standardizes PE ratios against companies' expected growth rates (g). Higher PEG ratio companies are
considered overvalued. Issues: EPS is a measure of
accounting profit only during a particular period.Accounting profits can be misleading because they include noncash and nonrecurring items, and accounting assumptions (such as historical vs. market costing), and can be manipulated.
Question 11: When is the PEG ratio most appropriate?
CORRECT ANSWER: Companies with positive
earnings but at different lifecycle stages. Meaningless for negative earnings or negative growth.