Chapter 5 - Valuation

Question 1

1. How do investment bankers value companies?

Answer 1

Investment bankers value companies using three primary methodologies:
comparable company analysis, precedent transaction analysis, and
discounted cash flow (DCF) analysis.

Question 2

2. What are the primary valuation methodologies that investment bankers
   use to value companies?

Answer 2

The primary valuation methodologies that investment bankers use to
value companies are the comparable company analysis, the precedent
transaction analysis, and the discounted cash flow (DCF) analysis.

Question 3

3. What is total enterprise value?

Answer 3

Total enterprise value is the value of the operations of a firm attributed
to all providers of capital.

Question 4

4. How do you calculate total enterprise value?

Answer 4

You calculate total enterprise value as the market value of equity plus
debt plus preferred stock less cash plus noncontrolling interest.

Question 5

5. What is the difference between total enterprise value and equity value?

Answer 5

Enterprise value represents the value of the operations of a company
attributable to all providers of capital. Equity value is one of the components
of enterprise value and represents only the proportion of value
attributable to shareholders.

Question 6

6. What is noncontrolling interest?

Answer 6

The balance sheet’s noncontrolling interest reflects the percentage of
the book value of a majority, but not wholly owned subsidiary that a
company does not own.

Question 7

7. Why do you add noncontrolling interest in the enterprise value
   formula?

Answer 7

You add noncontrolling interest in the enterprise value formula
because enterprise value is used in the numerator when calculating
various valuation ratios. Because of consolidation, the denominator
(i.e., revenue, EBITDA, or net income) will include 100 percent of
a majority but not wholly owned subsidiary. Therefore, to be consistent
with the denominator, you add the value of the subsidiary
that the company does not own to the enterprise value, so both are
overstated.

Question 8

8. Why do you subtract cash in the enterprise value formula?

Answer 8

Cash gets subtracted when calculating enterprise value because cash
is considered a nonoperating asset and because cash is already implicitly
accounted for within equity value.

Question 9

9. How do you calculate the market value of equity?

Answer 9

A company’s market value of equity (MVE) equals its share price
multiplied by the number of fully diluted shares outstanding.

Question 10

10. What is the difference between basic and fully diluted shares?

Answer 10

Basic shares represent the number of common shares that are outstanding
today (or as of the reporting date). Fully diluted shares equal
basic shares plus the potentially dilutive effect from any outstanding
stock options, warrants, convertible preferred stock, or convertible debt.

Question 11

11. How do you calculate fully diluted shares using the treasury stock method?

Answer 11

To use the treasury stock method, we first need a tally of the company’s
issued stock options and weighted average exercise prices. We
get this information from the company’s most recent 10‐K. If our calculation
will be used for a control‐based valuation methodology (i.e.,
precedent transactions) or M&A analysis, we will use all of the options
outstanding. If our calculation is for a minority interest based valuation
methodology (i.e., comparable companies) we will use only options
exercisable. Note that options exercisable are options that have vested
while options outstanding takes into account both options that have
vested and that have not yet vested.
Once we have this option information, we subtract the exercise price
of the options from the current share price (or per share purchase price
for an M&A analysis), divide by the share price (or purchase price), and
multiply by the number of options outstanding. We repeat this calculation
for each subset of options reported in the 10‐K. (Usually companies
will report several line items of options categorized by exercise price.)
Aggregating the calculations gives us the amount of diluted shares. If the
exercise price of an option is greater than the share price (or purchase
price), then the options are out of the money and have no dilutive effect.
We then add the number of dilutive shares to the basic share count to
get fully diluted shares (plus any effect from other dilutive securities).

Question 12

12. What are some examples of commonly used valuation multiples?

Answer 12

Probably the most common valuation metric used in banking is EV/
EBITDA. Some others include EV/sales, EV/EBIT, price to earnings
(P/E), and price to book value (P/BV).

Question 13

13. What is wrong with using a multiple such as EV/earnings or price/
    EBITDA?

Answer 13

Enterprise value (EV) equals the value of the operations of the company
attributable to all providers of capital. That is to say, because enterprise
value incorporates 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 enterprise value 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. These 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 applesto‐
oranges comparison and is considered inconsistent. Similarly price/
EBITDA is inconsistent because price (or equity value) is dependent on
capital structure (levered) while EBITDA is unlevered (again, applesto‐
oranges). Price/earnings is fine (apples‐to‐apples) because they are
both levered.

Question 14

14. What are some factors to consider when picking comps?

Answer 14

Some factors to consider when picking comps include finding companies
that are in the same industry with the same type of business model,
operate in the same or similar geographies, are of similar size, and have
similar growth and risk characteristics.

Question 15

15. Walk me through a DCF.

Answer 15

In order to do a DCF analysis, first we need to project free cash flow
for a period of time (say, five years). Free cash flow equals EBIT less
taxes plus D&A less capital expenditures less the change in working
capital. Note that this measure of free cash flow is unlevered or debtfree.
This is because it does not include interest and so is independent of
debt and capital structure.
Next we need a way to predict the value of the company/assets for the
years beyond the projection period (five years). This is known as the terminal
value. We can use one of two methods to calculate terminal value:
either the perpetuity growth (also called the Gordon growth) method or
the terminal multiple method. To use the perpetuity growth method, we
must choose an appropriate rate by which the company can grow forever.
This growth rate should be modest (for example, average long‐term
expected GDP growth or inflation). To calculate terminal value we multiply
the last year’s free cash flow (year 5) by one plus the chosen growth
rate, and then divide by the discount rate less growth rate.
The second method, the terminal multiple method, is the one that is
more often used in banking. Here we take an operating metric for the
last projected period (year 5) and multiply it by an appropriate valuation
multiple. The most common metric to use is EBITDA. We typically
select the appropriate EBITDA multiple by taking what we concluded
for our comparable company analysis on a last twelve months (LTM)
basis.
Now that we have our projections of free cash flows and terminal
value, we need to “present value” these at the appropriate discount
rate, also known as weighted average cost of capital (WACC). Finally,
summing up the present value of the projected cash flows and
the present value of the terminal value gives us the DCF 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.

Question 16

16. How do you calculate free cash flow?

Answer 16

Free cash flow equals EBIT less taxes plus D&A less capital expenditures
less the change in working capital.

Question 17

17. Why do you use unlevered free cash flow?

Answer 17

You use unlevered free cash flow because we want the DCF value
concluded to be enterprise value.

Question 18

18. What is the terminal value and how do you calculate it?

Answer 18

Terminal value is the value of the company beyond the projection
period. We can use one of two methods for calculating terminal value:
either the perpetuity growth (also called the Gordon growth) method
or the terminal multiple method. To use the perpetuity growth method,
we must choose an appropriate rate by which the company can
grow forever. This growth rate should be modest (for example, average
long‐term expected GDP growth or inflation). To calculate terminal
value we multiply the last year’s free cash flow (year 5) by one
plus the chosen growth rate, and then divide by the discount rate less
growth rate.
The second method, the terminal multiple method, is the one that
is more often used in banking. Here we take an operating metric for
the last projected period (year 5) and multiply it by an appropriate
valuation multiple. The most common metric to use is EBITDA.
We typically select the appropriate EBITDA multiple by taking what
we concluded for our comparable company analysis on a last twelve
months (LTM) basis.

Question 19

19. Why do you present value the cash flows?

Answer 19

You present value the cash flows because we want to calculate the
enterprise value of the company at today’s value. Since money today
is worth more than money tomorrow, we need to discount or present
value all of the cash flows and the terminal value.

Question 20

20. Conceptually, what does WACC represent?

Answer 20

Conceptually, WACC represents the company’s blended cost of funds
or, alternatively, the investors’ blended required return for investing in a
company of this type of risk.

Question 21

21. What is the formula for WACC?

Answer 21

The formula for WACC is the cost of debt multiplied by the percentage
of debt in the capital structure multiplied by one minus the tax rate,
plus the cost of equity times the percentage of equity in the capital structure,
plus the cost of preferred stock times the percentage of preferred
stock in the capital structure.

Question 22

22. How do you calculate the cost of equity?

Answer 22

To calculate a company’s cost of equity, we typically use the Capital
Asset Pricing Model (CAPM). The CAPM formula states that the cost of
equity equals the risk‐free rate plus the multiplication of beta times the
equity risk premium. The risk‐free rate (for a U.S. company) is generally
considered to be the yield on a 10‐ or 20‐year U.S. Treasury bond. Beta
should be levered and represents the riskiness (equivalently, expected
return) of the company’s equity relative to the overall equity markets.
The equity risk premium is the amount that stocks are expected to outperform
the risk free rate over the long‐term.

Question 23

23. What is the CAPM formula?

Answer 23

The CAPM formula states the cost of equity equals the risk‐free rate
plus the multiplication of beta times the equity risk premium.

Question 24

24. What is beta?

Answer 24

Beta is a measure of the riskiness of a stock relative to the broader
market (for broader market, think S&P 500). 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 is used in the Capital Asset Pricing Model
(CAPM) for the purpose of calculating a company’s cost of equity. Beta
is calculated as the covariance between a stock’s return and the market
return divided by the variance of the market return.

Question 25

25. Why do you unlever and lever beta?

Answer 25

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 riskier 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 riskier.
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. This is known as unlevering beta. After unlevering
the betas, we can now use the appropriate “industry” beta (i.e.,
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.

Question 26

26. What is the formula for unlevering and levering beta?

Answer 26

Unlevered Beta = Levered Beta / (1 + ((Debt/Equity) × (1 – Tax Rate)))
Levered Beta = Unlevered Beta x (1 + ((Debt/Equity) × (1 – Tax Rate)))

Question 27

27. How do you calculate the cost of debt?

Answer 27

To calculate the cost of debt, we can use one of three methods. The
first method is to calculate the weighted average cost of debt for each of
the comparable companies based on each company’s different types of
debt outstanding, and the appropriate interest rates and yields on each
of those types of debt. Then we can take the mean/median or use judgment
to conclude the appropriate cost of debt for the company being
valued. The second method is to take the average credit rating for the
comparable companies and look up the appropriate yield to maturity
on bonds of that credit rating. The third, though least accurate, method
is to take the interest expense for each comparable company and divide
by the company’s average debt balance. Then take the mean/median or
use judgment to approximate the cost of debt for the company being
valued. For any of the methods we then need to multiply by one minus
the tax rate to calculate the post‐tax cost of debt.

Question 28

28. How would you value a biotechnology startup with one potential
    blockbuster drug that is currently in clinical trials?

Answer 28

To value a biotechnology startup without current revenue you would
probably need to run a DCF assuming the drug passes clinical trials and
goes to market. However, you would probability weight the DCF value
based on the likelihood that the drug does indeed pass trials.

Question 29

29. How do you use the three main valuation methodologies to conclude
    value?

Answer 29

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.

Question 30

30. Of the three main valuation methodologies, which ones would you expect
    to give you higher or lower value?

Answer 30

First, the precedent transactions methodology 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. 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).
The discounted cash flow (DCF) analysis will also likely result in a
higher valuation than the comparable company analysis because DCF is
also a control‐based methodology and because most projections tend to
be pretty optimistic. Whether DCF will be higher than precedent transactions
is debatable, but it 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.

Question 31

31. What are the advantages and disadvantages of each of the three main
    valuation methodologies?

Answer 31

An advantage of the comparable company methodology is that it
uses current market values to conclude value. Assuming there are good
comparable companies, it is usually the most important method when
valuing a company and is indeed the way in which the public market
does typically value publicly traded companies. However, it is less useful
if there are few or no good comparable companies, or if you are valuing
a company that has no revenue or EBITDA or net income.
An advantage of the precedent transaction methodology is that it reflects
the value that buyers were actually willing to pay for companies.
Remember that at the end of the day, value is what someone is willing
to pay. It can also be the most useful methodology when there are many
very recent and very relevant transactions. However, a large disadvantage
is that valuation multiples are highly sensitive to market conditions,
and often precedent transactions will reflect deals that occurred over
many years and over different types of market conditions. Plus, deal
dynamics can play an important role in determining the purchase price
of a transaction, and these deal dynamics may have a material impact
on valuation multiples for a particular deal that may make that deal less
relevant. Finally, valuation multiples for this methodology tend to show
a wider range of values than do the comparable company methodology.
An advantage of the discounted cash flow methodology is that it can
be performed for any type of company, even a pre‐revenue company.
Because it is so variable to the forecasts and other impacts, it is also easy
to conclude a wide range of values from the DCF, which is helpful when
you need to match a preconceived notion of value. Finally, it is theoretically
the correct way to value a company. A very large disadvantage of
the DCF is that it is very sensitive to the cash flow forecasts, WACC,
and terminal multiple or perpetuity growth factor, which makes it very
unreliable.

Question 32

32. What are some other valuation methodologies that you might use to
    value a company?

Answer 32

Other valuation methodologies include leverage buyout (LBO) analysis,
sum of the parts analysis, replacement value, and liquidation value.