2.4) Valuation Multiples Flashcards
- What IS a valuation multiple?
A valuation multiple is shorthand for a company’s value based on its Cash Flow, Cash Flow Growth Rate, and Discount Rate. You could value a company with this formula: Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate But instead of providing all that information, valuation multiples let you use a number like “10x” and express it in a condensed way. You can also think of valuation multiples as “per-square-foot” or “per-square-meter” values when buying a house: they help you compare houses or companies of different sizes and see how expensive or cheap they are, relative to similar houses or companies.
- How do you use valuation multiples in real life?
Most often, you use them in “Comparable Company Analysis” or “Public Comps” when you find public companies similar to the one you’re analyzing and use their multiples to value your company. For example, you might screen companies by geography, industry, and financial size so that they are similar to your company.Then, you look at the growth rates of various metrics and their corresponding multiples to see how your company is currently priced. For example, if the median EBITDA growth of this set of companies is 10%, and your company is growing at 20%, but your company’s TEV / EBITDA and the median TEV / EBITDA of the set are similar, then perhaps your company is undervalued. If the companies are truly comparable, then they should have similar Discount Rates and Cash Flow figures. So, the differences in Cash Flow Growth Rates should explain most of the difference in the multiples.
- Why are valuation multiples and growth rates often NOT as correlated as you might expect?
The first problem is that company valuation is based on cash flow, which is different from metrics like EBIT and EBITDA (which are just approximations of cash flow). So, even if a company’s EBITDA growth is 10%, its Cash Flow growth might be 5% or 20% or (5%) due to items like Taxes, the Change in Working Capital, and so on. Also, it’s difficult to find 100% comparable companies in most industries, so there will usually be differences in the Discount Rates because the risk and potential returns will differ. Finally, “current events” always affect the multiples, even if they don’t change a company’s long-term performance. For example, legal troubles, a newly announced product, or a new executive could all change a company’s short-term market valuation.
- You’re valuing a mid-sized manufacturing company. This company’s TEV / EBITDA multiple is 15x, and the median TEV / EBITDA for the comparable companies is 10x. What’s the most likely explanation?
The most likely explanation is that the market expects this company’s cash flows to grow more quickly than those of the comparable companies. For example, other companies might be expected to grow at 5%, but this company might be expected to grow at 15%. The Discount Rate is unlikely to differ by a huge amount because these companies are all about the same size and are in the same industry, which means the risk and potential returns should be similar.
“Current events” could also affect the multiples, but it’s hard to say what they might be without additional information.
- Would you rather buy a company trading at a 10x TEV / EBITDA multiple, or one trading at a 5x multiple?
It depends on how each company compares to its peers, or comparable companies, in terms of growth rates and multiples. If the 10x company is growing at the same rate as its peer companies, but the peer companies are trading at multiples in the 13x-16x range, then the 10x company looks like a good deal. And if the 5x company is growing more slowly than its peer companies, despite trading in the same range (4-6x EBITDA), then the 5x company might be expensive for the growth it offers. When you buy companies, you always try to find ones that are undervalued – which means similar or lower multiples than peer companies, despite the same or higher growth.
- Walk me through how you calculate EBIT and EBITDA for a public company.
With EBIT, you start with the company’s Operating Income on its Income Statement and then add back any non-recurring charges that have reduced Operating Income. With EBITDA, you do the same thing and then add Depreciation & Amortization from the company’s Cash Flow Statement so that you get the all-inclusive number (D&A on the Income Statement is often embedded fully or partially in other line items there). You do not add back items like the Amortization of Debt Issuance Fees or the Amortization of Debt Discounts because they are typically components of the Net Interest Expense on the IS.
- Is anything different under U.S. GAAP vs. IFRS for these calculations? Do the multiples differ at all?
The main difference is that under U.S. GAAP, both EBIT and EBITDA fully deduct the Lease or Rental Expense, but under IFRS, they do not – because the Lease Expense is split into Interest and Depreciation elements. EBIT under IFRS deducts part of the Lease Expense, while EBITDA adds back or excludes the entire Lease Expense.
You still use Enterprise Value in the numerator of these valuation multiples, but under IFRS, you must add Operating Leases to Enterprise Value, and EBIT is no longer a valid metric (unless you adjust it). Under U.S. GAAP, no adjustment for Operating Leases is required, and TEV / EBIT and TEV / EBITDA are both valid multiples as-is.
- How do you calculate “Free Cash Flow” (just FCF, not Levered or Unlevered FCF), and what does it mean? Are there any differences under U.S. GAAP vs. IFRS?
Free Cash Flow is defined as Cash Flow from Operations – Capital Expenditures, assuming that Cash Flow from Operations deducts the Net Interest Expense, Taxes, and the full Lease Expense. It tells you how much Debt principal the company could repay, or how much it could spend on activities such as acquisitions, dividends, or stock repurchases. The main difference under the two accounting systems is that IFRS-based companies often start their Cash Flow from Operations sections with something other than Net Income, which means you may need to adjust CFO by subtracting the Net Interest Expense, the Interest element of the Lease Expense, or other items from elsewhere on the Cash Flow Statement. Also, under IFRS, you should not add back the entire D&A line item on the CFS – only the D&A that’s unrelated to the leases. That way, you ensure that the full Lease Expense is deducted.
- How do you calculate Unlevered FCF and Levered FCF, and how do you use them differently than normal Free Cash Flow?
Unlevered Free Cash Flow equals Net Operating Profit After Taxes (NOPAT) + D&A and sometimes other non-cash adjustments +/- Change in Working Capital – CapEx. Levered Free Cash Flow equals Net Income to Common + D&A and sometimes other non-cash adjustments +/- Change in Working Capital – CapEx – (Mandatory?) Debt Repayments + Debt Issuances (?). You normally use UFCF in DCF valuations because it lets you evaluate a company while ignoring its capital structure; FCF is more useful for standalone company analysis and determining a company’s Debt repayment capacity. LFCF is not useful for much of anything because people disagree about the basic definition, but you could use it in a Levered DCF, and it may better represent the Net Change in Cash.
- If a company’s cash flow matters most, why do you use metrics like EBIT and EBITDA in valuation multiples rather than FCF or UFCF?
Mostly for convenience and comparability. FCF and UFCF measure a company’s cash flow more accurately, but they also take more time to calculate since you need to review the full Cash Flow Statement and possibly adjust some of the items. Also, the individual items within FCF and UFCF vary quite a bit between different companies, regions, industries, and accounting systems, so you often need to normalize these figures, which requires discretion and explanation.
- How do you decide whether to use Equity Value or Enterprise Value when you create valuation multiples?
If the financial metric in the denominator of the valuation multiple deducts Net Interest Expense, then it pairs with Equity Value because the Debt Investors can no longer be “paid” after they earn their interest; only Equity Investors can earn something now. If the metric does not deduct Net Interest Expense, then it pairs with Enterprise Value. This rule applies to both financial metrics (EBIT, EBITDA, etc.) and non-financial ones (Unique Users, Subscribers, etc.).
- If a company has both Debt and Preferred Stock, why is it NOT valid to use Net Income rather than Net Income to Common when calculating its P / E multiple?
You can use Equity Value or Enterprise Value in multiples, but you shouldn’t create multiples that are based on metrics in between Equity Value and Enterprise Value. If you use Net Income rather than Net Income to Common, you’ll have to use Equity Value + Preferred Stock in the numerator – which is halfway to Enterprise Value, but missing the adjustments for Debt, Cash, etc. This numerator will confuse anyone looking at your analysis, so you should stick with the standard Equity Value metric and pair it with Net Income to Common.
- Should you use Equity Value or Enterprise Value with Free Cash Flow?
It depends on the type of Free Cash Flow. If the FCF metric deducts Net Interest Expense, i.e., it is either “Free Cash Flow” or Levered FCF, use Equity Value. If it does not deduct the Net Interest Expense, i.e., it is Unlevered FCF, use Enterprise Value.
- What are the advantages and disadvantages of TEV / EBITDA vs. TEV / EBIT vs. P / E?
First, note that you never look at just one multiple when valuing companies. You want to evaluate companies across different multiples and methodologies to get the big picture. But the interviewer will probably be annoying and press you on this point, so you can say that TEV / EBITDA is better in cases where you want to exclude the company’s CapEx and capital structure completely. TEV / EBIT is better when you want to ignore capital structure but partially factor in CapEx (via the Depreciation, which comes from CapEx in previous years). So, TEV / EBITDA is more about normalizing companies and more useful in industries where CapEx is not a huge value driver, while TEV / EBIT is better when you want to link CapEx to the company’s value (e.g., for an industrials company). The P / E multiple is not that useful in most cases because it’s affected by different tax rates, capital structures, non-core business activities, and more; you use it mostly as a “check,” and since it’s a standard multiple everyone knows.
- In the TEV / EBITDAR multiple, how do you adjust Enterprise Value?
If the denominator of a valuation multiple excludes or adds back an expense on the Income Statement, then the numerator should add the Balance Sheet item corresponding to that expense. EBITDAR is EBITDA + Rental Expense, so it adds back the Rental Expense. Therefore, in TEV, you must add the company’s on-Balance Sheet Operating Leases. Under IFRS, EBITDAR = EBITDA because companies do not record the Rental Expense at all, so (TEV + Operating Leases) / EBITDAR = (TEV + Operating Leases) / EBITDA.
