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.
Why do some stocks rise so much on the first day of trading and others don’t? How is that “money left on the table?”
By “money left on the table,” bankers mean that the company could have successfully completed the offering at a higher price, and that the difference in valuation thus goes to initial investors rather than the company. Why this happens and when it will happen is not easy to predict from responses received from investors during roadshows. Moreover, if the stock rises a lot the first day it is good publicity for the firm. But in many ways it is money left on the table because the company could have sold the same stock in its initial public offering at a higher price. However, bankers must honestly value a company and its stock over the long-term, rather than simply trying to guess what the market will do. Even if a stock trades up significantly initially, a banker looking at the long-term would expect the stock to come down, as long as the market eventually correctly values it.
Inventory: Assets: % of Sales
Liabilities: % of COGS
What’s the formula for discounting cash flows?
NPV = Cash Flow * (1/(1+r))^N
How do you calculate a compound annual growth rate?
CAGR = (Ending/Beginning)^(1/(Periods - 1) - 1
How do you calculate the WACC? CAPM?
WACC = CE*E% + CD*(1-T)*D% CAPM = RFR + B*(Market Risk Premium)
Can I apply CAPM in Latin American countries?
CAPM was developed for US markets; however, it is presently the best known tool for calculating discount rates.
While CAPM is not exact, it is a good framework for thinking about and analyzing discount rates outside of the US as markets are based on similar principles.
What should you consider when using valuing an international company?
(1) Use local companies to value local companies
(2) With cross border comparisons, consider different accounting rules, different interest rates (e.g. lower interest rates mean higher valuations and higher P/E), and different risk (e.g. emerging markets vs US)
(3) Use local currency and translate at the end
How would you value an apple tree?
Look at comparable apple trees and their values (relative valuation)
Discount the apple tree’s cash flows (intrinsic valuation)
How do you select comparable companies and transactions?
(1) Industry classification (2) Financial criteria (revenue, EBITDA, etc) (3) Geography
* Precedent transactions are limited to last 3-4 years
Company A is currently trading at a P/E ratio of 15x. It acquires a business with $10 million in EBITDA using 100% debt financing at a cost of debt of 10%. How much can it pay and still maintain its 15x P/E ratio?
TBU
Assume that subway tokens are $1.50 today and the price will go up to $2.00 tomorrow. How many tokens would you buy? (Silver Lake
First, you must ask what the cost of capital is. Assuming 10% cost of capital for simplicity, your return is (2.00 – 1.50) / 1.50 = 33% and in three year you would earn a return of (1.00 + 0.10)^3 = 33%. Thus, you would buy three years’ worth of tokens.
What does a multiple imply about your return? (Silver Lake)
The inverse of TEV / EBITDA is a proxy for your return.
How do investment bankers increase net income through 1) Restructuring 2) M&A 3) Debt issuance 4) Equity?
Restructuring – negotiate debt on more favorable terms (i.e. debt with lower interest rates)
M&A – combined income and possible synergies
Debt issuance – negative income from interest expense but positive income from interest revenue or organic growth
Equity – positive income from interest revenue or organic growth
What is working capital? How would you calculate it?
It is a measure of both a company’s operational efficiency and its short-term financial health. The working capital ratio is calculated as:
NWC = Current Assets – Current Liabilities
Positive working capital means that the company is able to pay off its short-term liabilities. Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory)
If a company’s current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company’s sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller.
Working capital also gives investors an idea of the company’s underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company’s obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company’s operations.
*Note: when considering an acquisition, we subtract cash because we assume it will be used to pay down debt and we subtract short-term debt because it is purchased as reflected in the transaction price
What happens to FCF if NWC increases?
FCF decreases because you subtract the change in NWC in the calculation of FCF. Working capital is the net dollars that are tied up to run the business. Thus, as more cash is tied up (either in accounts receivable, inventory, etc), there will be less FCF generated
How would you value a company with no revenue?
Make reasonable assumptions about the company’s projected cash flows for future years (~10 years) and then construct a DCF model of those cash flows using an appropriate rate.
Alternatively, you could use other operating metrics to value the company.
If you took a start-up with 50,000 subscribers, but no revenue, you could look at a similar website’s value per subscriber and apply that multiple to the website you are valuing
How much would you pay for a company with $50 million in revenue and $5 million in profit?
To value this company, you must use multiples or a precedent transaction analysis
How do you calculate the discount rate of an all equity firm?
Use CAPM to calculate the discount rate. rU = rF + bU(rM – rF)
What is CAPM?
It is a framework used to calculate the required / expected return on an investment or the cost of equity of a company. The formula is: rE = rF + bE (rM – rF)
The equity beta is a measure of how volatile the stock is in relation to the market (which refers to a well-diversified index such as the S&P 500)
*Note: CAPM takes into account the sensitivity to non-diversifiable risk, which is represented by beta and the expected market excess return
Assume that you use levered free cash flows rather than unlevered free cash flows. What is the effect? What discount rate should you use?
Levered free cash flows leads to equity value rather than enterprise value since the cash flow is only available to equity investors. (Debt investors have already been paid with interest payments). You must use the cost of equity rather than WACC because we are no concerned with debt or preferred stock.
Why do internet companies receive multibillion valuations when they have very low revenues?
Investors are anticipating extremely high future earnings due to their reach and growth trajectory and are less focused on presents revenues and margins.
Investors believe that these companies will be able to tap into the earnings power of their millions of users in some way that they are not currently doing.
Additionally, other companies are willing to pay astronomical premiums for a small equity stake
Why would you not use DCF analysis for a bank or other financial institute?
(1) Banks use debt differently than other companies and do not reinvest it into the business. Instead, they use it to create financial instruments.
(2) Interest is a critical part of a bank’s business model and working capital takes up a huge part of its balance sheet so a DCF does not make much sense
* More common valuation methodology is dividend discount model. Value of stock = dividend per share / (discount rate – dividend g)
Why does Warren Buffett prefer EBIT multiples to EBITDA multiple?
“Does management think that the tooth fairy pays for capex?”
He dislikes EBITDA because it excludes the often sizeable capex companies make and hides how much cash they are actually using to finance their operations. He argues that there is a big disparity between EBIT and EBITDA in capital-intensive industries.
What is a comparable set?
A comparable set lists financial data, valuation metrics and ratio analyses on a set of comparable companies in an industry. It is used to value private companies or better understand how the market values a particular industry.
Identify comparable companies using buiness and financial characteristics and then rank according to relevance (Tier I: Pure-play, Tier II: Relevant)
- Business characteristics: industry, products, customers, geography
- Financial characteristics: size, profitability, leverage
What does spreading comps mean?
Process of calculating relevant multiples from a number of different comparable companies and summarizing them for easy analysis and comparison
(1) Pros: good estimate for companies in the same sector
(2) Cons: not taking company capital structure into account (debt vs. equity)
* Most relevant multiple depends on the industry
Why would a company with similar growth and profitability to its comps be valued at a premium?
(1) Earnings beat expectations. Company may have recently reported earnings well above wall street estimates, and its stock price subsequently rose
(2) Competitive advantage. Company may have some sort of competitive advantage not reflected in its financials, such as a key patent or IP
(3) Lawsuit. Company may have received a favorable ruling in a lawsuit
(4) Market leader. Company may have greater market share than its competitors
Why are the PE multiples for a company in London different than that of the same company in the US?
PE multiples can be different in two countries even if all other factors are constant because of the difference in the way earnings are recorded.
Additionally, market valuations in American markets tend to be higher than those in the UK.
When might you see Equity Value / Revenue
It is rare. Sometimes large financial institutions with big cash balances have negative enterprise values. May also use for comparability of financial and non-financial institutes.
How would you value Facebook in 2004 when it had no revenue?
Use comparable companies and precedent transactions. Look at more creative multiples such as TEV / Unique Visitors
Would NOT use far in the future DCF because cannot reasonably predict cash flows for a company that is not even making money.
*Note: when you cannot reasonably predict cash flows, use other metrics
Why do we add preferred stock to the enterprise value of a company?
Because preferred stock holders provide capital to the firm and therefore, they have a claim to the company’s value. Preferred stock pays a fixed dividend and preferred stockholders have a higher claim to the company’s assets than equity holders. Preferred stock is more similar to debt than to common stock.
When might precedent transactions not produce a higher value than comparable companies?
Significant mismatch between the M&A market and the public market. For example, no public companies have been acquired recently but there have been a lot of small private companies acquired at extremely low valuations.
Which method of calculating TY value will result in a higher valuation?
It is hard to generalize. Both are highly dependent on the underlying assumptions. Generally, the multiple method will be more variable because exit multiples tend to span a wider range than possible long-term growth rates.
When would liquidation valuation produce the highest value?
This is highly unusual. However, it could happen if a company had substantial hard assets, but the market was severely undervaluing it for a specific reason (e.g. earnings miss of cyclicality). In this case, a company’s comparable and precedent transactions would be low. If the assets were valued high enough, liquidation value might yield a higher value
What would you use in conjunction with free cash flow multiples: equity value or enterprise value?
For unlevered free cash flow, use enterprise value
*Unlevered FCF excludes interest and thus represents money available to all shareholders and lenders
For levered free cash flow, use equity value
*Levered FCF already includes interest and the money is therefore only available to equity holders (i.e. debt investors have already been paid with the interest payments they received
What is the debt tax shield? How is it calculated?
Amount of money that a company saves by not having to pay taxes on its debt.
DTS = (T)(rD)(D)
- Main reason for the emergence of LBO shops; KKR borrowed money to buy RJR Nabisco at a price well above the market price
- Since the company had no debt before the takeover and has historically had highly reliable cash flows, KKR was able to increase the company’s value through a financial restructuring and save on taxes through the use of interest payments on debt and its accompanying write-offs
- Discount rate for DTS depends on which captures the risk associated with the DTS (reU or rD)
What discount rate do you use for the APV method?
Discount as if an all-equity firm. rU = rF + bU (rM – rF)
Why might there be multiple valuations for a single company?
There several different methods to value a company. Even if you use the most thorough and popular DCF method, WACC and APV make different assumptions about interest tax shields, which can lead to different valuations. This is the main reason why market valuations fluctuate
What should you do if you do not have faith in management’s projections?
(1) Create your own projections and construct a separate case in your model (2) Modify projections downward to make them more conservative (3) Show sensitivity tables based on different growth rates and margins and show the values under the different assumptions
How could a company have a negative equity value?
It is not possible to have a negative market value of equity because neither share price nor share count can be negative.
Should the cost of equity be higher for a $5 billion company or a $500 million company? What about WACC?
Cost of equity should be higher for the $500 million company because smaller companies are considered to be more risky and expected to outperform large companies in the stock market.
WACC depends on the capital structure of each company. All else equal, the $500 million company will have a higher WACC.
How do you know if your DCF is too dependent on future assumptions?
If significantly more than 50% of the company’s enterprise value comes from its TY value, then your DCF model is probably too dependent on future assumptions.
When might you see negative TEV?
A company with a large cash balance (e.g. financial institutes) or low market cap (e.g. company on brink of bankruptcy)
Why do we project FCF for a DCF model?
FCF is the amount of actual cash that could hypothetically be paid out to lenders and investors from the earnings of a company.
Is 10x a high PE ratio? What is the PE ratio for a high growth firm?
It depends. PE ratios are relative measurements.
In order to know whether a PE ratio is high or low, we need to know the general PE ratios of comparable companies.
Higher growth firms have higher PE ratios because their earnings will be low relative to their price, with the idea that the earnings will eventually grow more rapidly than the stock price
Assume that a company has 100 shares outstanding at $10 each. It also has 10 options outstanding with an exercise price of $5. What is the fully diluted equity value?
Basic Equity Value = $10 x 100 = $1,000
All options are in-the-money because the exercise price is below the current price. 10 new shares are created if exercised. The proceeds from the sale of options are $5 x 10 = $50. We can use this money to buy back $50/$10 = 5 of the newly created shares.
Fully Diluted Shares = 100 + 10 – 5 = 105
Fully Diluted Equity Value = $10 x 105 = $1,050
Which will typically pay a higher price for a company: strategic or financial buyer?
A strategic buyer would typically pay more for a company because of their willingness to pay a premium to potentially gain the synergies of lowering costs, improving their existing business and/or revenue synergies.
The financial buyer typically looks at the company purely in terms of returns on a standalone basis unless they have other companies in their portfolio that could significantly improve the operations of the target
You have two companies and each has a constant EBITDA of $50 in the foreseeable future. One is a manufacturing company and the other is a consulting firm. Which company do you think is more valuable?
???
Assume no interest and constant NWC because the companies are not growing. Tax rate is 50%
Manufacturing:
- Likely to have depreciation and capital expenditures
- Beta is likely to be less than one, which leads to a lower cost of equity
- Has tangible assets that can be used as collateral
Consulting:
- Not likely to have depreciation and capital expenditures
- Beta is likely to be above one, which leads to a higher cost of equity
- Majority of its assets are intangible (e.g. human capital)
You have two companies. Company A has EBITDA growing at 10% and Company B has EBITDA growing at 20%. Both companies are in the same industry and have the same capital structure. The industry average EBITDA growth rate is 15%. Which company would you invest in? Why? What are some disadvantages to the option you chose?
TBU
You are acquiring a company and are allowed to ask the CEO one question in order to determine how much you will pay. What would you ask? If you could ask one follow-up question, what would it be?
TBU - FCF. Growth in FCF.
What are the differences between a WACC and an asset beta?
TBU
What are the drawbacks of using WACC in valuing companies?
TBU
What is EBITDA? EBIT? Why are they important? When would you use EBIT vs. EBITDA?
TBU
What are multiples? How do you know which ones to use?
TBU
What is the difference between equity and enterprise ratios?
TBU
How does leverage influence PE ratios?
TBU
Enterprise Value is 100, Equity value if 150, what is net debt?
TBU
What would greater impact a firms valuation, a 10% reduction in revenues or 1% reduction in discount rate?
TBU
Which of the three valuation techniques (DCF, Comparable Companies, Precedent Transactions) is the best? Why?
TBU
What is the average P/E ratio within the S&P 500? Is Google’s P/E higher of lower? What is it? Is GE’s P/E higher or lower? What is it? Why is that?
TBU
What industry do you follow and what numbers do you look at to determine if a firm is doing well in the industry?
Technology – PEG
Growth Industries (no earnings) – P / Sales
Real Estate – P / FFO
Financial Institutes – P / BV
If a company has $30mm EBITDA, $20mm FCF, $100mm in debt and can sell itself for $300mm TEV, what is the break-even multiple after 2 years assuming no EBITDA growth?
TBU
If you put $100 in the bank and got back $2 every year for the next 19 years and then in the 20th year received $102, what is your IRR?
TBU
How do you begin with analyzing a new company?
TBU
How do you view maintenance, growth and acquisition capital expenditures when analyzing a company?
TBU
How do you forecast stability of cash flows?
TBU
How do you describe cyclicality and seasonality? Are they good or bad?
TBU
Why should the fair market value of a company be higher than its liquidation or going-concern value?
TBU
Walk me through pre and post deal equity valuation.
TBU
What analysis would you perform if you were presented with a management team’s financial plan?
TBU
What are the features of a good business model?
TBU
Explain why two companies might trade at different PE ratios.
TBU
Explain why two companies might trade at different TEV/EBITDA multiples.
TBU
A company has $10mm of cash, $1mm of shares and nothing else. What is its stock price? What if the company wins $10mm in the lotto? What if the company uses the lotto money to repurchase shares at $25/share? What’s the share price today if the repurchase is in one month?
TBU
