Business Analysis Valuation Flashcards
CFI
What is valuation?
Valuation is the art and science of attributing value to an asset, investment, or company.
Which are the three main valuation techniques?
The three main valuation techniques are:
- Asset Approach (FMV of net assets)— Cost to Build, Replacement Cost, and Liquidation Value.
- Intrinsic Value (Income approach): Looking at a company in isolation without worrying about peers. It doesn’t directly depend on the mood of the market since we’re more focus on the fundamentals of the company.—Discounted Cash Flows (DCF).
- Relative Value (Market approach): It is more likely to reflect the mood of the market and produce a valuation that is closer to market price than DCF. in precedent transactions, qe relate to past mergers and acquisitions. This form of valuation includes a takeover premium.—Public Company Comparables, Precedent Transactions.
What is the difference between enterprise value and equity value?
Enterprise value is the value of a company’s operations while equity value is the residual value of a business after all claims on the business have been paid.
Both measure the size of a company.
What are the advantage and disadvatange of enterprise value?
The advantage of enterprise value are:
* Enterprise value is more useful when comparaing companies with different capital structures.
Enterprise value minimizes accountign policies relative to net income and earnings per share.
The disadvantage of enterprise value are:
* Enterprise value is less useful for analyzing stocks since it measures the total business value, not the equity value.
* There are other debt and cahs-like itmes that may be difficult to measure.
What are the advantage and disadvantage of equity value?
The advantage of equity value are:
* Equity value is more relevant to equity valuation, which is just a portion of a business.
* It requires less judgment than enterprise value, where there is debate over cash and debt.
The disadvantages of equity value are:
* Equity value rely on accrual accounting, which can be manipulated.
* Different capital structures impact earnings, even if the business are otherwise identical.
How enterprise value is calculated?
- Enterprise value is the value of a company’s operations.
- Bonds and revolving credit line are consider debt whereas accounts payable and deferred revenues cannot be counted as debt.
- When a company has more cash and end up with net cash (cash is larger than debt) rather than net debt, this result in a lower enterprise value.
Describe valuation consistency.
Assets can be funded by either debt or equity.
* if a denominator is before interest expense, it’s an enterprise value multiple.
* * EV / Sales
* * EV / EBITDA
* * EV / EBITDA
* If a denominator is after interest expense, it’s an equity value multiple.
* * P / E
* * P / B
What are the most commonly use valuation technique in the industry?
The Discounted Cash Flow (Intrinsic Value or Income Approach)
What the intrinsic value approach consists of?
- The intrinsic value approach or income approach looks at the company in isolation without worrying about peers.
- Involves forecasting future performances, calculation future cash flows, and discounting back to the present (Discounted Cash Flow technique).
- It doesn’t directly depend on the mood of the market since it focuses more on the fundamentals of the company.
What the relative value approach consist of?
The relative value approach consist of two different techniques:
1. Public Company Comparable technique compares a company with comparable peers in the industry that are easy to find given that these companies shares are publicly traded on the stock exchange.
- With the public company comparable we use multiples to find the worth of the company we are trying to value (i.e., Price-to-earnings multiple).
- It is more likely to reflect the mood of the market and produce a valuation that is closer to market price than DCF.
2. Precedent Transactions relates to past mergers and acquisitions. This form of valuation includes a takeover premium (generally, more money is paid for a controlling position).
In which is the intrinsic value of an asset or business based on?
The intrinsic value of an asset or business is based on its future profits.
Describe the formula of discounted cash flows.
What are the types of Free Cash Flows?
There are two types of discounted cash flows calculations:
* Unlevered Free Cash Flow (UFCF), also known as Free Cash Flow to the Firm, is the cash flow that a business has before paying its debt obligations.
* Levered Free Cash Flow (LFCF): The cash flow a business has after it has met its debt obligations.
Why enterprise value is consider a unlevered metric?
Enterprise value is considered an unlevered metric because is not impacted by capital structure.
Which interest rate must be considered in the calculation of enterprise value through UFCF?
The interest rate to consider in order to discount the future cash flows of the company is the Weighted Average Cost of Capital (WACC) since we’re using the unlevered cash flows, and this cash flows are available to all providers of capital, debt inequity, there our discount rate must reflect the risk to all of those investors. WACC factors in the risk for both debt and equity.
What are analyst must consider in order to apply a DCF calculation?
- A DCF is easiest to use on a company that has positive and fairly predictable cash flows.
- A DCF becomes more difficult for younger companies and companies that are in financial distress.
- While a private company can be valued using a DCF, the most difficult par is estimating a discount rate.
What are the stages of DCF Forecast?
The further we predict into the future, the more prone to error our estimates become. Therefore, the DCF Forecast consist of two stages:
* Stage 1: Discrete Forecast involves calculating free cash flows each year based on projections within a time period typically of 5 to 10 years.
* Stage 2 : Terminal Value assumes cash flows grow infinitely at a steady rate or company is acquired at some multiple.
Regardless of the stage, the analyst will discount all cash flows and the terminal value back to the present at the appropriate discount rate.
What are the key assumptions of DCF?
Forecast Drivers
* Company management —A/R, Inventory, and A/P terms
* Industry Competition—Market size
* Treats and Challenges—Useful life, Maintenance, Scale
* Macroeconomic environment—Wage rates, taxes
* Microeconomic environment — Sales Mix, Volume/Price, Materials/Price, and Staffing Levels
Company
* Revenue
* Operating margin
* Taxes
* Working Capital
* Capital Expenditure
What are the methods to calculate Unlevered Free Cash Flows (UFCF) or Free Cash Flow to the Firm (FCFF)?
Define Weighted Average Cost of Capital (WACC).
WACC is the weighted average cost of debt and the cost of equity.
* The cost of debt is the yield on a company’s debt not the coupon. Given that interest rate usually is tax deductible, we need the after tax cost of debt which is Yield x (1-Tax rate).
* The cost of equity uses the Capital Asset Pricing Model or (CAPM) which is a risk-free rate plus β multiply for the equity risk premium.
How CAPM is calculated?
What are the factors that impact cost of equity?
- Some factors that impact the cost of equity for a business can be categorized by market risk and firm-specific risk.
- Diversified portfolios of stocks are only exposed to market risk, or β.
How to calculate beta for a public traded company?
For a publicly traded company with an active market, the β of a stock is estimated from the linear relationship between the returns on the stock (dependent variable) and the returns on a proxy for the market portfolio (independent variable). In the U.S., the proxy for the market portfolio is typically the S&P 500 Index.
* The slope of an ordinary least squares regression line of a stock’s returns on the returns of the market is used as an estimated β, a stock’s systematic risk.
* The estimate of β is affected by the choice of the proxy overall market portfolio, by the length of the total period selected, and by the time period for the individual returns. In practice, 60 observations of monthly returns are most often used.
* A stock’s β estimated in this manner is referred to as a “raw” or “unadjusted” β. Studies have shown that stock betas move toward one over time. To adjust for this reversion toward one, the following adjustment is used:
How to calculate beta for a target stock that isn’t publicly traded?
For a (target) stock that isn’t publicly traded or that is simply very thinly (infrequently) traded, we can estimate its β from the returns on a comparable stock or group of comparable stocks that are actively traded.
* We can select a stock or group of stocks from the same industrial classification or identify a stock or stocks that have similar business risks to our target company (a peer company or a peer group of companies).
* For companies that are comparable in their business risk, their individual betas will vary due to differences in their use of financial leverage and the tax rates they are subject to. To account for these differences, we begin with the β of a company or group of companies that are purely engaged in a business similar to that of the target company.
* The β of a firm is a function of the business risk of its lines of business and its financial structure. The greater a firm’s reliance in debt financing, the greater its equity β.
* For this reason, we must adjust the β from a comparable compay (or group of companies) for its leverage and tax rate (unlever it) to get the comparable company’s assets β (unlevered β). We can the adjust the comparable company’s asset β (re-lever it) based on the financial leverage and the marginal tax rate of the target company. We can then use this equity β in the CAPM equation to estimate the cost of equity of the target company.
