Advanced - Valuation

Question 1

What are the 3 major valuation methodologies?

Answer 1

1. Public Company comparables (public comps) - relative valuation
2. Precedent Transactions (trading comps) - relative valuation
3. Discounted Cash Flow analysis - intrinsic valuation

Question 2

Can you walk me through how you use Public Comps and Precedent Transactions?

Answer 2

1. Select the universe of comparable companies based on key criteria (e.g. industry‚ financial metrics‚ geography)
2. Locate the necessary financial information
3. Spread key statistics‚ ratios‚ and trading multiples (e.g. revenue‚ revenue growth‚ EBITDA‚ EBITDA margins‚ revenue and EBITDA multiples)
4. Benchmark the comparable companies (min.‚ 25%ile‚ median‚ 75%ile‚ max)
5. Apply multiples & determine valuation

Question 3

How do you select Comparable Companies or Precedent Transactions?

Answer 3

1. Business Profile (sector‚ products and services‚ customers and end markets‚ distribution channels‚ geography)
2. Financial Profile (size‚ profitability‚ growth profile‚ return on investment‚ credit profile)

Question 4

For Public Comps‚ you calculate Equity Value and Enterprise Value for use in multiples based on companies’ share prices and share counts… but what about for Precedent Transactions? how do you calculate multiples there?

Answer 4

• multiples should be based on the purchase price of the company at the time of the deal announcement (the affected share price)
• you only care about what the offer price was at the initial deal announcement. You never look at the company’s value prior to the deal being announced.

Question 5

How would you value an apple tree?

Answer 5

• same way you would value a company: what are comparable apple trees worth? (relative valuation)
• present value of FCF for the apple (intrinsic valuation)

Question 6

When is a DCF useful? When is it not useful?

Answer 6

• DCF is best when the company is large‚ mature‚ and has stable and predictable cash flows (the far-in-the-future assumptions will be more accurate)
• DCF is not as useful if the company has unstable or unpredictable cash flows (start-up) or when Debt and Operating Assets & Liabilities serve fundamentally different roles (financial institutions)

Question 7

What other valuation methodologies are there?

Answer 7

• Liquidation Valuation: valuing a company’s assets‚ assuming they are sold off and then subtracting Liabilities to determine how much capital‚ if any‚ equity investors receive
• LBO Analysis: determining how much a PE firm could pay for a company to hit a target IRR‚ usually in the 20-25% range
• Sum of the Parts: Valuing each division of a company separately and adding them together at the end
• M&A Premiums Analysis: analyzing M&A deals and figuring out the premium that each buyer paid‚ and using this to establish what your company is worth
• Future Share Price Analysis: projecting a company’s share price based on the P/E multiples of the public company comparables and then discounting it back to its present value

Question 8

When is a Liquidation Valuation useful?

Answer 8

• Most common in bankruptcy scenarios and is used to see whether or not shareholders will receive anything after the company’s Liabilities have been paid off with the proceeds from selling all its Assets
• Often used to advise struggling businesses whether it’s better to sell off Assets or sell 100% of company

Question 9

When would you use a Sum of the Parts Valuation?

Answer 9

For conglomerates that have completely unrelated divisions (e.g. GE)
• Should use different comparable sets for each division‚ value each division separately‚ and then add them back together to calculate Total Value

Question 10

When do you use an LBO Analysis as part of your valuation?

Answer 10

• obviously for LBOs
• used to “set a floor/lower bound” on company valuation‚ min. amount that PE firm would be willing to pay to achieve targeted returns
• often see it used when both strategics (normal companies) and financial sponsors are competing to buy the same company and you want to determine the potential price if a PE firm were to acquire the company.

Question 11

How do you apply the valuation methodologies to value a company?

Answer 11

• Present range of valuations from different methodologies on a “football field”
• to do this‚ calculate min.‚ 25%ile‚ median‚ 75%ile‚ max values for each set (2-3 years of comps and the transactions‚ for each different multiple used) and then multiply by the relevant metrics for the company you’re analyzing)
• For public companies‚ you will also work backwards to calculate Equity Value and implied per Share Price based on this.

Question 12

Can you walk me through how to calculate EBIT and EBITDA? How are they different?

Answer 12

• EBIT is just a company’s operating income on its I/S‚ it includes not only COGS and operating expenses‚ but also non-cash expenses such as D&A and therefore reflects‚ at least indirectly‚ the company’s CapEx
• EBITDA is defined as EBIT plus D&A. You may sometimes add back other expenses
• The idea of EBITDA is to move closer to a company’s “cash flow‚” since D&A are non-cash expenses‚ but the problem is that you exclude CapEx altogether

Question 13

Can you walk me through how to calculate Unlevered FCF (FCF to Firm) and Levered FCF (FCF to Equity)?

Answer 13

• Unlevered FCF = EBIT*(1 - Tax Rate) + Non-cash expenses - Change in Operating Assets & Liabilities - CapEx
• Levered FCF = Net Income + Non-Cash expenses - Change in Operating Assets & Liabilities - CapEx - Mandatory Debt Repayments

Question 14

What are the most common valuation multiples? And what do they mean?

Answer 14

• EV/Revenue: how valuable a company is relative to its overall sales
• EV/EBITDA: how valuable a company is relative to its approximate cash flow
• EV/EBIT: how valuable a company is relative to the pre-tax profit it earns from its core business operations
• P/E: how valuable a company is in relation to its after-tax profits‚ inclusive of interest income and expense and other non-core business activities
• Other multiples include P/BV‚ EV/Unlevered FCF‚ Equity Value/Levered FCF
• EV/Unlevered FCF is closer to true cash flow than EV/EBITDA but takes more work to calculate‚ and Equity Value/Levered FCF is even closer‚ but is affected by company’s capital structure and takes even more time to calculate.

Question 15

How are the key operating metrics and valuation multiples correlated? In other words‚ what might explain a higher or lower EV/EBITDA multiple?

Answer 15

• Usually there is a correlation between growth and valuation multiples
• Math also plays a role‚ sometimes companies w/ extremely high EBITDA margins may have lower EBITDA multiples because EBITDA itself is much higher to begin with (and its in the denominator)

Question 16

Why can’t you use Equity Value / EBITDA as a multiple rather than EV/EBITDA?

Answer 16

Equity Value/EBITDA is comparing apples to oranges because equity value does not reflect the company’s entire capital structure (only what is available to common shareholders).

Question 17

What would you use with Free Cash Flow multiples - Equity Value or Enterprise Value?

Answer 17

• For Unlevered FCF‚ you use enterprise value (cash flow available to all investors)
• For levered FCF‚ you use equity value (cash flow available to equity investors)

Question 18

Why does Warren Buffet prefer EBIT multiples to EBITDA multiples?

Answer 18

• WB dislikes EBITDA b/c it hides the CapEx companies make and disguises how much cash they require to finance their operations
• Any industry that is capital intensive and asset-heavy will have a huge disparity between EBIT and EBITDA
• Note: EBIT itself does NOT include CapEx but it includes depreciation (which is directly linked to CapEx). If a company has high depreciation‚ chances are it has high CapEx spending

Question 19

What are some problems with EBITDA and EBITDA multiple? And if there are so many problems‚ why do we still use it?

Answer 19

• It hides the amount of debt principal and interest that a company is paying each year‚ which can be very large and make company cash flows negative‚ also hides CapEx spending
• EBITDA also ignores working capital requirements (e.g. A/R‚ Inv.‚ A/P)‚ which can be large for some companies
• in a lot of cases EBITDA may not even be close to true cash flow‚ it’s widely used for convenience and comparability (better for comparing cash generated by a company’s core business operations than other metrics)

Question 20

The EV/EBIT‚ EV/EBITDA‚ and P/E multiples all measure a company’s profitability. What’s the difference between them‚ and when do you use each one?

Answer 20

• P/E is dependent on company’s capital structure‚ EV/EBIT and EV/EBITDA are capital structure-neutral. So you use P/E for financial institutions where interest is critical and capital structures are similar.
• EV/EBIT includes D&A‚ where EV/EBITDA excludes it‚ more likely to use EV/EBIT in industries where D&A is large and where CapEx and fixed assets is important (manufacturing) and EV/EBIT where fixed assets are less important and where D&A is comparatively smaller (e.g. internet companies)

Question 21

Could EV/EBITDA ever be higher than EV/EBIT for the same company?

Answer 21

• No‚ by definition EBITDA must be greater than or equal to EBIT‚ b/c EBITDA = EBIT + D&A (neither of which can be negative‚ can be $0 theoretically)
• Since EBITDA is always greater than or equal to EBIT‚ EV/EBITDA must always be less than or equal to EV/EBIT for a single company

Question 22

What are some examples of industry-specific multiples?

Answer 22

• Technology/Internet: EV/Unique Visitors‚ EV/Page Views
• Retail/Airlines: EV/EBITDAR (EBITDA + Rental Expense)
• Oil & Gas: EV/EBITDAX (EBITDA + Exploration Expense)‚ EV/Production‚ EV/Proved Reserves
• Real Estate Investment Trusts (REITs): Price/FFO per Share‚ Price/AFFO per Share (Funds from Operations‚ Adj. Funds from Operations)

Question 23

When you’re looking at an industry specific multiple like EV/Proved Reserves or EV/Subscribers (for telecom companies‚ for example)‚ why do you use Enterprise Value rather than Equity Value?

Answer 23

Enterprise Value is used b/c those proved reserves or subscribers are “available” to all the investors (both debt and equity) in a company. This is almost always the case unless the metric already includes interest income and expense (FFO & AFFO)

Question 24

Rank the 3 main valuation methodologies from highest to lowest expected value.

Answer 24

Trick question - there is no one ranking that will always hold up.
• In general‚ precedent transactions will be higher than comparable public companies due to the control premium built into acquisitions (buyer must pay premium to acquire seller)
• DCF could go either way‚ best to say it’s just more variable than other methodologies. Often produces highest value‚ but can produce lowest value as well depending on assumptions.

Question 25

Would an LBO or DCF produce a higher valuation?

Answer 25

Technically‚ could go either way‚ but in most cases LBO gives lower valuation.
• With LBO‚ you do not get any value form the cash flows of a company in between Year 1 and the final year‚ you only get “value” out of its final year
• With DCF‚ you’re taking into account both the company’s cash flows in the period itself as well as the terminal value‚ so values tend to be higher
• Note: unlike DCF‚ the LBO model itself does not give you a valuation‚ you start with a target IRR and then back-solve the implied valuation of the company (how much sponsor could pay)

Question 26

When would a Liquidation produce the highest value?

Answer 26

highly unusual‚ but could happen if company has substantial hard assets but market was severely undervaluing it for a specific reason (missed earnings or cyclicality)

Question 27

Why are public comps and precedent transactions sometimes viewed as being “more reliable” than a DCF?

Answer 27

• b/c they’re based on actual market data vs. assumptions about the future
• note you still need to make future assumptions (Forward Year 1‚ Forward Year 2)
• also‚ sometimes you may not have good or truly comparable data‚ in which case a DCF might produce better results

Question 28

What are the flaws with Public Company Comparables?

Answer 28

• no company is 100% comparable to another company
• stock market is “emotional”‚ multiples might be dramatically higher or lower on certain dates depending on market movements
• share prices for small companies w/ thinly traded stocks may not reflect full value

Question 29

You mentioned that Precedent Transactions usually produce a higher value than Comparable Companies - can you think of a situation where this is not the case?

Answer 29

• this can occur when there is substantial mismatch between M&A markets and public markets. For example‚ no public companies have been acquired recently but lots of small private companies have been acquired at low valuations

Question 30

What are some flaws with Precedent Transactions?

Answer 30

• past transactions are rarely 100% comparable - the transaction structure‚ size of the company‚ and market sentiment all make a huge impact
• data on precedent transactions is generally more difficult to find than it is for public company comparables‚ esp. for acquisitions of small private companies

Question 31

How would you present these Valuation methodologies to a company or its investors? And what do you use it for?

Answer 31

• usually you use a “football field” chart where valuation ranges are implied by each methodology. You ALWAYS show a range rather than one specific number
• you could use a valuation for: 1) pitch books and client presentations‚ 2) parts of other models (defense analyses‚ merger models‚ LBO models‚ DCFs‚ almost everything in finance will incorporate a valuation in some way‚ 3) fairness opinions

Question 32

Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium?

Answer 32

• Company has just reported earnings well above expectations and its stock price has risen in response
• has some type of competitive advantage not reflected in financials‚ such as a key patent or other intellectual property
• just won a favorable ruling in a major lawsuit
• is the market leader in an industry and has greater market share than its competitors

Question 33

How do you take into account a company’s competitive advantage in a valuation?

Answer 33

1. Highlight the 75th percentile or higher for the multiples rather than the median
2. Add in a premium to some of the multiples
3. Use more aggressive projections for the company

Question 34

Do you ALWAYS use the median multiple of a set of public company comparables or precedent transactions?

Answer 34

No‚ you almost always show a range. You may make the median the center of the range‚ but you don’t have to (you could focus on 75%ile‚ 25%ile or anything else‚ depending on if the company is outperforming‚ underperforming‚ etc.)

Question 35

Two companies have the exact same financial profiles (revenue‚ growth‚ and profits) and are purchased by the same acquirer‚ but the EBITDA multiple for one transaction is twice the multiple of the other transaction - how could this happen?

Answer 35

• One process was more competitive and had a lot more companies bidding on the target
• One company had recent bad news or a depressed stock price so it was acquired at a discount
• They were in industries w/ different median multiples
• The two companies have different accounting standards and have added back different items when calculating EBITDA‚ so the multiples are not truly comparable

Question 36

If you were buying a vending machine business‚ would you pay a higher EBITDA multiple for a business that owned the machines and where they depreciated normally‚ or one in which the machines were leased? The depreciation expense and the lease expense are the same dollar amounts and everything else is held constant.

Answer 36

Higher multiple for the one w/ leased machines‚ all else being equal.
• Purchase Enterprise Value would be the same for both acquisitions‚ but depreciation is excluded from EBITDA‚ so EBITDA is higher (dep. exp. added back)
• For the company w/ the lease‚ the lease expense would show up in operating expenses‚ making EBITDA lower and the EV/EBITDA multiple higher to get to the same EV.

Question 37

How would you value a company that has no profit and no revenue?

Answer 37

1. You could use the Comparable Companies and the Precedent Transactions and look at more “creative” multiples such as EV/Unique Visitors and EV/Pageviews (internet start-ups) rather than EV/Revenue or EV/EBITDA
2. You could use a “far-in-the-future” DCF and project a company’s financials out until it actually earns revenue and profit (e.g. biotech and pharmaceutical firms)

Question 38

The S&P500 Index has a median P/E multiple of 20x. A manufacturing company you’re analyzing has earnings of $1M. How much is the company worth?

Answer 38

Depends on how it’s performing relative to the index and relative to companies in its own industry (outperforming can lead to $25-30M‚ performing on par would be $20M‚ or underperforming would be

Question 39

A company’s current stock price is $20/share and its P/E multiple is 20x‚ so its EPS is $1. It has 10M shares outstanding. Now it does a 2-for-1 stock split - how do its P/E multiple and valuation change?

Answer 39

They don’t
• Company has 20M shares outstanding‚ but equity value has stayed the same‚ so share price will fall to $10‚ EPS falls to $0.50‚ and P/E multiple remains at 20x
• Splitting stock into fewer units or additional units does not‚ by itself‚ make a company worth more or less (in practice‚ a stock split is viewed favorably by the market and a company’s value may go up and it’s share price‚ in this case‚ might not necessarily be cut in half)

Question 40

Let’s say that you’re comparing a company with a strong brand name‚ such as Coca-Cola‚ to a generic manufacturing or transportation company. Both companies have similar growth profiles and margins. Which one will have the higher EV/EBITDA multiple?

Answer 40

• Most likely the firm with the strong brand will get the higher valuation
• Remember that valuation is not a science‚ it’s an art‚ and the market can behave irrationally. Values are not based strictly on financial criteria‚ and other factors such as brand name or “trendiness” can all make an impact.