05. Valuation Flashcards
What is valuation?
Valuation is the procedure of calculating the worth of an asset, security or company
What reasons for a valuation analysis?
(1) Buy-side engagement
(2) Sell-side engagement
(3) Divestitures
(4) Fairness opinion
(5) Hostile defense
(6) IPO
(7) Credit purposes
(8) Equity research or portfolio management
What are the four main valuation methodologies?
(1) Comparable company analysis: provides the company’s implied value in the public equity markets through analysis of comparable companies’ trading and operating statistics; median multiple from comparable set multiplied by the operating metric of the company you are valuing
* Usually a discount of 10% to 40% is applied to private companies due to the lack of liquidity of their shares
(2) Precedent transaction analysis: median multiple paid in past M&A transactions similar to the current deal multiplied by the operating metric of the company you are valuing
* Results in the highest valuation because it includes a control premium that a company will pay for the assumed synergies
(3) DCF analysis: value of the company equals the cash flows the company can produce in the future. An appropriate discount rate is used to calculate a net present value of projected cash flows
(4) LBO: assuming a given IRR (usually 20% to 30%), what would a financial buyer be willing to pay? Usually provides a floor valuation. Determine that max value you can pay using maximum leverage, which can also help assess amount of initial debt possible
Discuss why one technique may be a more accurate assessment of value than another?
Market valuation might not necessarily be fair. As a result, you might consider using other techniques to determine the fair value of a company
(1) Comparable companies – appropriate when you expect convergence to more efficient valuations in the market
Pros:
-Primary measure for IPOs
-Based on publicly available info
-Market efficiency implies that the trading valuation should reflect all available info (e.g. risk, trends, etc.)
Cons:
- Difficult to find truly comparable companies
- Does not include control premium or synergies
- Not good for thinly traded stocks
- Stock market includes a lot of speculation that may be irrational
(2) Precedent transactions – appropriate for transactions involving control stakes
Pros:
-Primary measure for M&A because it includes control premium
-Trends become clear (i.e. a lot of deals suggests industry consolidation)
Cons:
- Not enough relevant data points
- Degree of comparability is questionable
- Market cycles and volatility may affect valuations
- Not forward looking
(3) DCF – appropriate for longer holding periods
Pros:
-UFCF is relatively free of accounting manipulations
-Good rough estimate
-No market volatility
Cons:
- Number of assumptions makes this method problematic (constant D/E, TY value, growth, etc)
- Heavily dependent on cash flow projections
- Forecasting the future is an imperfect methodology
- Management tends to overestimate projections
- Heavy reliance on TY value
Of the four main valuation methodologies, which ones are likely to result in higher/lower value?
Precedent Transactions (M&A comps) – is likely to give a higher valuation than the Comparable Company methodology. This is because when companies are purchased, the target’s shareholders are typically paid a price that is higher than the target’s current stock price. Technically speaking, the purchase price includes a “control premium” (~20%). Valuing companies based on M&A transactions (a control based valuation methodology) will include this control premium and therefore likely result in a higher valuation than a public market valuation (minority interest based valuation methodology). If the buyer believes it can achieve synergies with the merger, then the buyer may pay more. This is known as the synergy premium.
DCF – Although it is difficult to generalize, the DCF analysis will also likely result in a higher valuation than the Comparable Company analysis because DCF is also a control based methodology (meaning you select the assumptions that determine the value) and because most projections tend to be pretty optimistic. Whether DCF will be higher than Precedent Transactions is debatable but is fair to say that DCF valuations tend to be more variable because the DCF is so sensitive to a multitude of inputs or assumptions.
Comparable Companies – based on other similar companies and how they are trading in the market and no control premium or synergies
LBO – Between LBOs and DCFs, the DCF should have a higher value because the required IRR (cost of equity) of an LBO should be higher than the public markets cost of equity in WACC for the DCF. The DCF should be discounted at a lower rate and yield a higher value than an LBO.
Regardless, all interviewers are looking for you to say that the DCF and precedents yield higher valuations than the other two methodologies for the reasons listed above.
What do you think is the best method of valuation?
Depends on the situation. Ideally, you’d like to triangulate all three main methods: precedents, trading comps and DCF. However, sometimes there are good reasons to heavily weight one over the others. A company could be fundamentally different from its peers, with a much higher/lower growth rate or risk and projections for future cash flows is very reasonable, which makes a good case to focus on the DCF. Or you may prefer trading comps over precedents because there are few precedents available or the market has fundamentally changed since the time those precedents occurred (i.e., 2006 was an expensive year due to the availability of leverage).
How do you use the three main valuation methodologies to conclude value?
The best way to answer this question is to say that you calculate a valuation range for each of the three methodologies and then “triangulate” the three ranges to conclude a valuation range for the company or asset being valued. You may also put more weight on one or two of the methodologies if you think that they give you a more accurate valuation. For example, if you have good comps and good precedent transactions but have little faith in your projections, then you will likely rely more on the Comparable Company and Precedent Transaction analyses than on your DCF.
How do you determine which valuation method to use?
The best way to determine the value of a company is to use a combination of all the methods and zero in on an appropriate valuation. If you have a precedent transaction that you feel is extremely accurate, then you can give that method more weight. If you are extremely confident in your DCF, then you can give that method more weight.
Valuing a company is much more art than it is science.
What are some other possible valuation methodologies in addition to the main three?
(1) Liquidation valuation – valuing a company’s assets assuming they are sold off and then subtracting liabilities to determine how much capital, if any, is leftover for equity investors
(2) Replacement valuation – valuing a company based on the cost of replacing its assets
(3) LBO Analysis – determining how much a PE firm could pay for a company to hit a target IRR (usually 20-30%)
(4) Sum-of-the-Parts – valuing each division of a company separately and adding them together to reach a combined value
When would you use a sum-of-the-parts valuation?
When a company has completely unrelated divisions (e.g. General Electric). Use different set of comparable companies for each division, value each one separately and add them together to get a combined value
When would you use liquidation valuation?
Most common in bankruptcy scenarios and is used to see whether equity holders will receive any capital after the company’s debts have been paid off. It is often used to advise struggling businesses on whether it is better to sell off assets separately or to try and sell the entire company
What are some common valuation metrics?
PE Ratio – criticized because it includes interest and taxes, which might not be the same post acquisition
TEV / Sales – explains how companies with low profits have such high market caps
TEV / EBITDA – probably the most common valuation metric used in banking
EV / EBIT
P / BV
*Note that the most relevant multiple depends on the industry
What is a PE ratio and why do analysts use it?
PE Ratio = price per share / earnings per share. Analysts use this figure to look at how the market values a particular company with respect to earnings (LTM or NTM) relative to other comparable companies.
Analysts may also use a PEG ratio (PE / Growth), which adjusts for differences in growth amongst firms.
What is the calculation for EPS?
EPS = (Net Earnings – Preferred Stock Dividends) / Common Shares
EPS is the portion of a company’s profit allocated to each outstanding share of common stock. It is calculated after paying taxes and after paying preferred stock and bondholders
*Note: fully diluted EPS includes stock options, warrants, and convertible securities, but basic EPS does not count these securities
Does preferred stock trade at a discount or premium to common stock and why? Convertibles?
Convertible bonds trade at a premium to common stock because investors see value in the convertible nature of the investment. Also, transaction costs for convertibles are frequently less than those for buying common stock, and the duration before a bond can be converted applies upward pressure on the convertible bond
Why can’t you use EV/Earnings or Price/EBITDA as valuation metrics?
Enterprise Value (EV) equals the value of the operations of the company attributable to all providers of capital. That is to say, because EV incorporates all of both debt and equity, it is NOT dependent on the choice of capital structure (i.e. the percentage of debt and equity). If we use EV in the numerator of our valuation metric, to be consistent (apples to apples) we must use an operating or capital structure neutral (unlevered) metric in the denominator, such as Sales, EBIT or EBITDA. Such metrics are also not dependent on capital structure because they do not include interest expense. Operating metrics such as earnings do include interest and so are considered leveraged or capital structure dependent metrics. Therefore EV/Earnings is an apples to oranges comparison and is considered inconsistent. Similarly Price/EBITDA is inconsistent because Price (or equity value) is dependant on capital structure (levered) while EBITDA is unlevered. Again, apples to oranges. Price/Earnings is fine (apples to apples) because they are both levered.
What options would you consider to raise a depressed stock price?
(1) Stock repurchase program
(2) Dividend increase
(3) Structural or strategic changes (e.g. M&A, divestitures, etc.)
What is the difference between enterprise value and equity value?
Enterprise Value represents the value of the operations of a company attributable to all providers of capital (i.e. all investors). Equity Value is one of the components of Enterprise Value and represents only the proportion of value attributable to shareholders (this is the number that the public sees).
What is Enterprise Value? What is the formula?
Enterprise value is the value of a firm as a whole, to both debt and equity holders. It represents the value of the operations of a company attributable to all providers of capital.
TEV = Market value of equity (MVE) + debt + preferred stock + minority interest - excess cash.
How do you calculate the market value of equity?
A company’s market value of equity (MVE) equals its share price multiplied by the number of fully diluted shares outstanding.
How do you calculate free cash flow to the firm? To equity?
To the firm (unlevered free cash flow; debt and equity holders): EBITDA less taxes less capital expenditures less increase in net working capital.
- Unlevered FCF = EBIT(1 – T) + D&A + Increase in NWC – Capex
- Use WACC to determine Enterprise Value
To equity (levered free cash flow; equity holders only): Same as firm FCF and then less interest and any required debt amortization. *Levered FCF = UFCF – Cash Interest – Preferred Dividends +/- issuance or repayment of debt & preferred shares
What is FCF?
Measure of cash that a company has left over after paying for its existing operations
How do you calculate FCF from net income?
FCF = Net Income + D&A – Capex – Change in NWC
How do you get from EBITDA to unlevered free cash flow?
UFCF = EBITDA – EBIT(1 – T) – Capex – Change in NWC
What are three pit falls of the WACC method?
(1) Assumes a constant capital structure
(2) Difficult to estimate an appropriate growth rate when calculating the TY value
(3) In theory, DCF analysis is for valuing a firm’s projects. It is a stretch to argue that all the projects of the firm (i.e. the whole firm) should be valued the same way.
What is the Adjusted Present Value method?
(1) Discount projected UFCF using the discount rate for an all-equity firm (rU or the unlevered equity discount rate as derived using CAPM)
(2) Discount the debt tax shield separately. DTS = (T) (rD) (Total Debt for that Year) OR APV approximation = (APV w/o DTS) (T) (D/V)
(3) Add the present value of the cash flows and the debt tax shield
*Note: debt tax shield is the amount of money a company saves by not having to pay taxes on its debt
What is the difference between the APV and WACC methods?
WACC incorporates the effects of interest tax shields into the discount rate. Typically calculated from actual data from the balance sheet and used for a company with a consistent capital structure over the period of the valuation.
APV adds present value of financing effects to NPV assuming all-equity firm. Useful where costs of financing are complex and capital structure is changing. Use APV for LBOs. The primary shorting coming is that it is difficult to project the cost of financial distress
What is the difference between basic shares and fully diluted shares?
Basic shares represent the number of common shares that are outstanding today (or as of the reporting date). Fully diluted shares equals basic shares plus the potentially dilutive effect from any outstanding stock options, warrants, convertible preferred stock or convertible debt. In calculating a company’s market value of equity (MVE) we always want to use diluted shares. Implicitly the market also uses diluted shares to value a company’s stock.
Why do you subtract cash in the enterprise value formula? Is this method always accurate?
In some sense we don’t subtract cash. We are netting it against debt to get net debt.
(1) Cash is considered a non-operating asset
(2) Cash is already implicitly accounted for in the market cap
(3) You can use that cash to pay off some of the debt, or pay yourself a dividend, effectively reducing the purchase price of a company
* In an acquisition, the buyer absorbs the cash of the seller, so it effectively pays less for the company based on how large its cash balance is
This method is not always accurate because when we subtract cash, to be precise, we should specify excess cash. However, we will typically make the assumption that a company’s cash balance (including cash equivalents such as marketable securities or short-term investments) equals excess cash.
What is Minority Interest and why do we add it in the Enterprise Value formula?
When a company owns more than 50% of another company, U.S. accounting rules state that the parent company has to consolidate its books. In other words, the parent company reflects 100% of the assets and liabilities and 100% of financial performance (revenue, costs, profits, etc.) of the majority-owned subsidiary (the “sub”) on its own financial statements. But since the parent company does not own 100% of the sub, the parent company will have a line item called minority interest on its income statement reflecting the portion of the sub’s net income that the parent is not entitled to (the percentage that it does not own). The parent company’s balance sheet will also contain a line item called minority interest which reflects the percentage of the sub’s book value of equity that the parent does NOT own. It is the balance sheet minority interest figure that we add in the Enterprise Value formula.
Now, keep in mind that the main use for Enterprise Value is to create valuation ratios/metrics (e.g. EV/Sales, EV/EBITDA, etc.) When we take, say, sales or EBITDA from the parent company’s financial statements, these figures due to the accounting consolidation, will contain 100% of the sub’s sales or EBITDA, even though the parent does not own 100%. In order to counteract this, we must add to Enterprise Value, the value of the sub that the parent company does not own (the minority interest). By doing this, both the numerator and denominator of our valuation metric account for 100% of the sub, and we have a consistent (apples to apples) metric.
One might ask, instead of adding minority interest to Enterprise Value, why don’t we just subtract the portion of sales or EBITDA that the parent does NOT own. In theory, this would indeed work and may in fact be more accurate. However, typically we do not have enough information about the sub to do such an adjustment (minority owned subs are rarely, if ever, public companies). Moreover, even if we had the financial information of the sub, this method is clearly more time consuming.
Walk me through a Discounted Cash Flow analysis.
(1) Project free cash flow for a period of time (e.g. five years)
UFCF = EBIT(1 – T) + D&A – Capex – Change in NWC
*Note that this measure of free cash flow is unlevered or debt-free. This is because it does not include interest and is thus independent of debt and capital structure
(2) Calculate appropriate discount rate, WACC
WACC = (E/V)rE + (P/V)rP + (1 – T)(D/V)rD
(3) Calculate TY Value – predict the value of the company/assets for the years beyond the projection period (e.g. 5 years)
- Terminal Multiple method – more common; take an operating metric for the last projected period (year 5) and multiply it by an appropriate valuation multiple; select appropriate EBITDA multiple by taking what we concluded for our comparable company analysis on a LTM basis
- Gordon Growth (Perpetuity Growth) method – must choose a modest growth rate around average long-term GDP or inflation growth rate (~3%). TY Value = UFCF5(1 + g) / (r – g)
(4) Discount cash flows and TY value back to year 0 using WACC – sum up the present value of the projected cash flows and the present value of the TY value to give us the NPV = DCF value = Enterprise Value
* Note that because we used unlevered cash flows and WACC as our discount rate, the DCF value is a representation of Enterprise Value, not Equity Value.
What is WACC and how do you calculate it?
It is the discount rate used in a DCF analysis to present value projected free cash flows and TY value. Conceptually, WACC represents the blended opportunity cost to lenders and investors of a company or set of assets with a similar risk profile. It reflects the risk of the whole company
WACC reflects the cost of each type of capital (debt, equity and preferred stock) weighted by the respective percentage of each type of capital assumed for the company’s optimal capital structure.
WACC = (E/V)rE + (1 – T)(D/V)rD + (P/V)rP
- To estimate the cost of equity, we will typically use CAPM
- To estimate the cost of debt, we can analyze the interest rates/yields on debt issued by similar companies
- To estimate the cost of preferred, we can analyze the dividend yields on preferred stock issued by similar companies
When is it not appropriate to use DCF analysis?
(1) Unstable or unpredictable cash flows (e.g. tech start-ups)
(2) Debt and WC serve fundamentally different role (e.g. banks do not reinvest debt and working capital is a huge part of their balance sheets)
How do you calculate the cost of equity?
To calculate a company’s cost of equity, we typically use the Capital Asset Pricing Model. The CAPM formula states the cost of equity equals the risk free rate plus the multiplication of Beta times the equity risk premium.
- rF (for a U.S. company) is generally considered to be yield on 10 or 20 year US Treasury Bond.
- Beta should be levered and represents the riskiness (equivalently, expected return) of the company’s equity relative to the overall equity markets
- Equity risk premium is the amount that stocks are expected to outperform the risk free rate over the long-term (6-7%)
What is Beta?
Beta is a measure of the riskiness or volatility of a stock relative to the market as a whole (e.g. S&P500, Wilshire 5000, etc). Beta is used in the capital asset pricing model (CAPM) for the purpose of calculating a company’s cost of equity.
By definition the “market” has a Beta of one (1.0). So a stock with a Beta above 1 is perceived to be more risky than the market and a stock with a Beta of less than 1 is perceived to be less risky.
Beta < 1: consumer staples, healthcare, utilities, tobacco, petroleum production
Beta > 1: wireless networking, bio-tech, computer software, e-commerce, entertainment
*Note that beta is calculated as the covariance between a stock’s return and the market return divided by the variance of the market return.
What effects does debt have on beta?
Stocks that have debt are somewhat riskier than stocks without debt because
(1) Increases risk of bankruptcy
(2) Ties up funds that could be used to grow the business
(3) Reduces flexibility of management
What is EBITDA?
Earnings before interest, taxes, depreciation and amortization. It is used as a proxy for a company’s cash flows. Although it is not useful for equity investing, EBITDA is the most important financial metric in debt investing. It is a good metric for comparing the performance of different firms because it strips out the effects of financing and accounting decisions.
When using the CAPM for purposes of calculating WACC, why do you have to unlever and then relever Beta?
In order to use the CAPM to calculate our cost of equity, we need to estimate the appropriate Beta. We typically get the appropriate Beta from our comparable companies (often the mean or median Beta). However before we can use this “industry” Beta we must first unlever the Beta of each of our comps. The Beta that we will get (say from Bloomberg or Barra) will be a levered Beta.
Recall what Beta is: in simple terms, how risky a stock is relative to the market. Other things being equal, stocks of companies that have debt are somewhat more risky that stocks of companies without debt (or that have less debt). This is because even a small amount of debt increases the risk of bankruptcy and also because any obligation to pay interest represents funds that cannot be used for running and growing the business. In other words, debt reduces the flexibility of management which makes owning equity in the company more risky.
Now, in order to use the Betas of the comps to conclude an appropriate Beta for the company we are valuing, we must first strip out the impact of debt from the comps’ Betas (i.e. remove the financial effects of leverage). This is known as unlevering Beta. Unlevered beta shows you how much risk a firm’s equity has compared to the market. Comparing unlevered betas allows an investor to see how much risk he will be taking on by investing in a company’s equity.
After unlevering the Betas, we can now use the appropriate “industry” Beta (e.g. the mean of the comps’ unlevered Betas) and relever it for the appropriate capital structure of the company being valued. After relevering, we can use the levered Beta in the CAPM formula to calculate cost of equity.
*Example: when you have Company A that does not have a beta, you can find comparable Company B, take their levered beta, unlever it, and then relever it using Company A’s capital structure to find its beta
What are the formulas for unlevering and levering Beta?
Unlevered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Debt/Equity)))
Levered Beta = Unlevered Beta x (1 + ((1 - Tax Rate) x (Debt/Equity)))
How would you calculate the equity (levered) beta of a company?
In order to calculate an equity beta, you must perform a regression of the return of the stock vs the return of the market as a whole (e.g. S&P 500). Slope of the regression line is the equity beta.
How do you calculate FCF?
EBIT(1 – T) + D&A – Capex – Change in NWC
How do you calculate a company’s terminal year value?
(1) Terminal multiple method: assign a valuation multiple (e.g. TEV/EBITDA) to the final year’s projection (point at which company is stable) and use that as the TY value
* Note that we typically select the appropriate EBITDA multiple by taking what we concluded for our comparable company analysis on a last twelve months (LTM) basis
(2) Perpetuity growth method: choose modest growth rate, usually around the long-term average inflation rate or GDP growth rate, in order to assume that the firm can grow at this rate infinitely. Use the perpetuity formula in order to come up with the value in that year.
TY Value = FCF(1 + g) / (WACC – g)
Other methods: stable perpetuity w/o growth (UFCF / WACC) liquidation value (i.e. fire-sale)
When might you use the perpetuity growth method rather than the terminal multiple method?
Almost always use terminal multiple method in banking because it is much easier to get appropriate data for exit multiples since they are based on comparable companies. Picking a long-term growth rate is sort of a shot in the dark.
Might use Gordon growth method if you have no good comps or if you have reason to believe the multiples will change significantly in the industry several years down the road (e.g. industry is cyclical)
If you have two companies that are exactly the same (revenue, growth, risk, etc) but one is private and one is public, which company’s shares would be priced higher?
Public company will be priced higher due to the liquidity premium one would pay to be able to quickly and easily buy/sell the shares in the public markets.
Another reason the public company would be priced higher would be the transparency the firm is required to have in order to be listed on a public exchange.
What kind of investment would have a negative beta?
One example is gold. When the stock market goes up in value, the price of gold drops as people flee from the safe haven of gold. The opposite occurs when the stock market declines. Thus, there is a negative correlation.
What is the market risk premium?
Return that investors require for investing in stocks over investing in risk free securities such as a 10 year Treasury note. Premium = average market return (~12%) – RFR (~3.5%) = 8.5%
Which is less expensive capital, debt or equity?
Debt is less expensive for two main reasons. First, interest on debt is tax deductible (i.e. the tax shield). Second, debt is senior to equity in a firm’s capital structure. That is, in a liquidation or bankruptcy, the debt holders get paid first before the equity holders receive anything. Note, debt being less expensive capital is the equivalent to saying the cost of debt is lower than the cost of equity.
