Compta 5 - Valorisation Flashcards
What’s the point of valuation? WHY do you value a company?
But public companies already have Market Caps and Share Prices. Why bother valuing them?
You value a company to determine its Implied Value according to your views of it.
If this Implied Value is very different from the company’s Current Value, you might be able to invest in the company and make money if its value changes.
If you are advising a client company, you might value it so you can tell management the price that it might receive if the company sells, which is often different from its Current Value. Because a company’s Market Cap and Share Price reflect its Current Value according to “the market as a whole” – but the market might be wrong!
What are the advantages and disadvantages of the 3 main valuation methodologies?
Public Comps are useful because they’re based on real market data, are quick to calculate and explain, and do not depend on far-in-the-future assumptions.
However, there may not be truly comparable companies, the analysis will be less accurate for volatile or thinly traded companies, and it may undervalue companies’ long-term potential.
Precedent Transactions are useful because they’re based on the real prices that companies have paid for other companies, and they may better reflect industry trends than Public Comps.
However, the data is often spotty and misleading, there may not be truly comparable transactions, and specific deal terms and market conditions might distort the multiples.
DCF Analysis is the most “correct” methodology according to finance theory, it’s less subject to market fluctuations, and it better reflects company-specific factors and long-term trends.
However, it’s also very dependent on far-in-the-future assumptions, and there’s disagreement over the proper calculations for key figures like the Cost of Equity and WACC.
Which of the 3 main methodologies will produce the highest Implied Values?
This is a trick question because almost any methodology could produce the highest Implied Values depending on the industry, time period, and assumptions.
Precedent Transactions often produce higher Implied Values than the Public Comps because of the control premium – the extra amount that acquirers must pay to acquire sellers.
But it’s tough to say how a DCF stacks up because it’s far more dependent on your assumptions.
The best answer is: “A DCF tends to produce the most variable output since it’s so dependent on your assumptions, and Precedent Transactions tend to produce higher values than the Public Comps because of the control premium.”
When is a DCF more useful than Public Comps or Precedent Transactions?
You should pretty much always build a DCF since it IS valuation – the other methodologies are supplemental
But it’s especially useful when the company you’re valuing is mature and has stable, predictable cash flows, or when you lack good Public Comps or Precedent Transactions.
When are Public Comps or Precedent Transactions more useful than the DCF?
If the company you’re valuing is early-stage, and it is impossible to estimate its future cash flows, or if the company has no path to positive cash flows, you have to rely on the other methodologies.
These other methodologies can also be more useful when you run into problems in the DCF, such as an inability to estimate the Discount Rate or extremely volatile cash flows.
Which one should be worth more: A $500 million EBITDA healthcare company or a $500 million EBITDA industrials company?
Assume the growth rates, margins, and all other financial stats are the same.
In all likelihood, the healthcare company will be worth more because healthcare is a less assetintensive industry. That means the company’s CapEx and Working Capital requirements will be lower, and its Free Cash Flow will be higher (i.e., closer to EBITDA) as a result.
Healthcare, at least in some sectors, also tends to be more of a “growth industry” than industrials.
The Discount Rate might also be higher for the healthcare company, but the lower asset intensity and higher expected growth rates would likely make up for that.
However, this answer is an extreme generalization, so you would need more information to make a real decision.
How do you value an apple tree?
The same way you value a company: Comparables and a DCF. You’d look at what similar apple trees have sold for, and then calculate the expected future cash flows from this tree.
You would then discount these cash flows to Present Value, discount the Terminal Value to PV, and add up everything to determine the apple tree’s Implied Value
The Discount Rate would be based on your opportunity cost – what you might be able to earn each year by investing in other, similar apple trees.
People say that the DCF is an intrinsic valuation methodology, while Public Comps and Precedent Transactions are relative valuation.
Is that correct?
No, not exactly. The DCF is based on the company’s expected future cash flows, so in that sense, it is “intrinsic valuation.”
But the Discount Rate used in a DCF is linked to peer companies (market data), and if you use the Multiples Method to calculate Terminal Value, the multiples are also linked to peer companies.
The DCF depends less on the market than the other methodologies, but there is still some dependency.
It’s more accurate to say that the DCF is more of an intrinsic valuation methodology than the others.
Why do you build a DCF analysis to value a company?
You build a DCF analysis because a company is worth the Present Value of its expected future cash flows:
Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate.
But you can’t just use that single formula because a company’s Cash Flow Growth Rate and Discount Rate change over time.
So, in a Discounted Cash Flow analysis, you divide the valuation into two periods: One where those assumptions change (the explicit forecast period) and one where they stay the same (the Terminal Period).
You then project the company’s cash flows in both periods and discount them to their Present Values based on the appropriate Discount Rate(s).
Then, you compare this sum – the company’s Implied Value – to the company’s Current Value or “Asking Price” to see if it’s valued appropriatel
Walk me through a DCF analysis
A DCF values a company based on the Present Value of its Cash Flows in the explicit forecast period plus the Present Value of its Terminal Value.
You start by projecting the company’s Free Cash Flows over the next 5-10 years by making assumptions for revenue growth, margins, Working Capital, and CapEx.
Then, you discount the cash flows using the Discount Rate, usually the Weighted Average Cost of Capital, and sum up everything.
Next, you estimate the company’s Terminal Value using the Multiples Method or the Gordon Growth Method; it represents the company’s value after those first 5-10 years into perpetuity.
You then discount the Terminal Value to Present Value using the Discount Rate and add it to the sum of the company’s discounted cash flows.
Finally, you compare this Implied Value to the company’s Current Value, usually its Enterprise Value, and you’ll often calculate the company’s Implied Share Price so you can compare it to the Current Share Price.
How do you move from Revenue to Free Cash Flow in a DCF?
First, confirm that the interviewer is asking for Unlevered Free Cash Flow (AKA Free Cash Flow to Firm). If so:
Subtract COGS and Operating Expenses from Revenue to reach Operating Income (EBIT).
Then, multiply Operating Income by (1 – Tax Rate), add back Depreciation & Amortization, and factor in the Change in Working Capital.
If the company spends extra cash as it grows, the Change in Working Capital will be negative; if it generates extra cash flow as a result of its growth, it will be positive.
Finally, subtract Capital Expenditures to calculate Unlevered Free Cash Flow.
Levered Free Cash Flow (Free Cash Flow to Equity) is similar, but you subtract the Net Interest Expense before multiplying by (1 – Tax Rate), and you also factor in changes in Debt principal
What does the Discount Rate mean?
The Discount Rate represents the opportunity cost for the investors – what they could earn by investing in other, similar companies in this industry.
A higher Discount Rate means the risk and potential returns are both higher; a lower Discount Rate means lower risk and lower potential returns.
A higher Discount Rate makes a company less valuable because it means the investors have better options elsewhere; a lower Discount Rate makes a company more valuable.
How do you calculate Terminal Value in a DCF, and which method is best?
You can use the Multiples Method or the Gordon Growth Method (AKA Long-Term Growth Method, Perpetuity Growth Method, etc.).
With the first one, you apply a Terminal Multiple to the company’s EBITDA, EBIT, NOPAT, or FCF in the final year of the forecast period. For example, if you apply a 10x EV / EBITDA multiple to the company’s Year 10 EBITDA of $500, its Terminal Value is $5,000.
With the Gordon Growth Method, you assign a “Terminal Growth Rate” to the company’s Free Cash Flows in the Terminal Period and assume they’ll grow at that rate forever.
Terminal Value = Final Year Free Cash Flow * (1 + Terminal Growth Rate) / (Discount Rate – Terminal Growth Rate)
The Gordon Growth Method is better because growth always slows down over time; all companies’ cash flows eventually grow more slowly than GDP.
If you use the Multiples Method, it’s easy to pick a multiple that makes no logical sense because it implies a growth rate that’s too high.
However, many bankers still use and prefer the Multiples Method because it’s “easier” or because they don’t understand the need to cross-check the output.
What are some signs that you might be using the incorrect assumptions in a DCF?
- Too Much Value from the PV of Terminal Value – It usually accounts for at least 50% of the company’s total Implied Value, but it shouldn’t account for, say, 95% of its value.
- Implied Terminal Growth Rates or Terminal Multiples That Don’t Make Sense – If you pick a Terminal Multiple that implies a Terminal FCF Growth Rate of 8%, but the country’s long-term GDP growth rate is 3%, something is wrong.
- You’re Double-Counting Items – If an income or expense line item is included in FCF, you should not count the corresponding Asset or Liability in the Implied Enterprise Value Implied Equity Value “bridge” at the end. And if a line item is excluded from FCF, you should count the corresponding Asset or Liability in the “bridge” at the end.
- Mismatched Final Year FCF Growth Rate and Terminal Growth Rate – If the company’s Free Cash Flow is growing at 15% in the final year, but you’ve assumed a 2% Terminal Growth Rate, something is wrong. FCF growth should decline over time and approach the Terminal Growth Rate by the end of the explicit forecast period
If your DCF seems off, what are the easiest ways to fix it?
The simplest method is to extend the explicit forecast period so that the company’s Free Cash Flow contributes more value, and so that there’s more time for FCF growth to slow down and approach the Terminal Growth Rate.
So, if you’re using a 5-year forecast period, extend it to 10-15 years and reduce the company’s FCF growth in those extra years as it approaches maturity.
To avoid double-counting items… look at what you’re doing and don’t double count!
finally, you can reduce the Terminal Value by picking a lower Terminal Growth Rate or lower Terminal Multiple. Terminal Value tends to be overstated in financial models because people don’t understand the theory behind it.
How do you interpret the results of a DCF?
You compare the company’s Implied Enterprise Value, Equity Value, or Share Price to its Current Enterprise Value, Equity Value, or Share Price to see if it might be overvalued or undervalued.
You do this over a range of assumptions because investing is probabilistic.
For example, if you believe that the company’s Implied Share Price is between $15.00 and $20.00, but its Current Share Price is $8.00, then that is good evidence that the company may be undervalued.
But if its Current Share Price is $17.00, then it may be valued appropriately.
Does a DCF ever make sense for a company with negative cash flows?
Yes, it may. A DCF is based on a company’s expected future cash flows, so even if the company is cash flow-negative right now, the analysis could work if it starts generating positive cash flows in the future.
If the company has no path to positive cash flows, or you can’t reasonably forecast its cash flows, then the analysis doesn’t make sense
How do the Levered DCF Analysis and Adjusted Present Value (APV) Analysis differ from the Unlevered DCF?
In a Levered DCF, you use Levered FCF for the cash flows and Cost of Equity for the Discount Rate, and you calculate Terminal Value using Equity Value-based multiples such as P / E.
You don’t back into Implied Equity Value at the end because the analysis produces the Implied Equity Value directly.
An APV Analysis is similar to a traditional Unlevered DCF, but you value the company’s Interest Tax Shield separately and add the Present Value of this Tax Shield at the end
You still calculate Unlevered FCF and Terminal Value in the same way, but you use Unlevered Cost of Equity for the Discount Rate (i.e., Risk-Free Rate + Equity Risk Premium * Median Unlevered Beta from Public Comps).
You then project the Interest Tax Shield each year, discount it at that same Discount Rate, calculate the Interest Tax Shield Terminal Value, discount it, and add up everything at the end.
Will you get the same results from an Unlevered DCF and a Levered DCF?
No. The simplest explanation is that an Unlevered DCF does not factor in the interest rate on the company’s Debt, while the Levered DCF does.
That alone will create differences, but the volatile cash flows in a Levered DCF (due to changes in Debt principal) will also contribute; it’s very difficult to pick “equivalent assumptions” in both analyses.
Why do you typically use the Unlevered DCF rather than the Levered DCF or APV Analysis?
The traditional Unlevered DCF is easier to set up, forecast, and explain, and it produces more consistent results than the other methods.
With the other methods, you have to project the company’s Cash and Debt balances, Net Interest Expense, and changes in Debt principal, all of which require more time and effort.
The Levered DCF sometimes produces odd results because Debt principal repayments can spike the Levered FCF up or down in individual years.
The APV Analysis is flawed because it doesn’t factor in the main downside of Debt: Increased chances of bankruptcy. You can try to reflect this risk, but no one agrees on how to estimate it numerically.
The Unlevered DCF solves this issue because WACC decreases with additional Debt, at first, but then starts increasing past a certain level, which reflects both the advantages and disadvantages of Debt
Why do you calculate Unlevered Free Cash Flow by including and excluding various items on the financial statements?
Unlevered FCF must capture the company’s core, recurring line items that are available to ALL investor groups.
That’s because Unlevered FCF corresponds to Enterprise Value, which also represents the value of the company’s core business available to all investor groups.
So, if an item is NOT recurring, NOT related to the company’s core business, or NOT available to all investor groups, you leave it out.
This rule explains why you exclude all of the following items: • Net Interest Expense – Only available to Debt investors.
• Other Income / (Expense) – Corresponds to non-core-business Assets.
• Most non-cash adjustments besides D&A – They’re non-recurring.
• All Items in Cash Flow from Financing – They’re only available to certain investors.
• Most of Cash Flow from Investing – Only CapEx is a recurring, core-business item.
How does the Change in Working Capital affect Free Cash Flow, and what does it tell you about a company’s business model?
The Change in Working Capital tells you whether the company generates more cash than expected as it grows, or whether it requires more cash to fuel that growth.
It’s related to whether a company records expenses and revenue before or after paying or collecting them in cash.
For example, retailers tend to have negative values for the Change in Working Capital because they must pay for Inventory upfront before they can sell products.
But subscription-based software companies often have positive values for the Change in Working Capital because they collect cash from long-term subscriptions upfront and recognize it as revenue over time.
The Change in WC could increase or decrease the company’s Free Cash Flow, but it’s rarely a major value driver because it’s fairly small for most companies
Should you add back Stock-Based Compensation to calculate Free Cash Flow? It’s a noncash add-back on the Cash Flow Statement.
No! You should consider SBC a cash expense in the context of valuation because it creates additional shares and dilutes the existing investors.
By contrast, Depreciation & Amortization relate to timing differences: The company paid for a capital asset earlier on but recognizes that payment over many years.
Stock-Based Compensation is a non-cash add-back on the Cash Flow Statement, but the context is different: Accounting rather than valuation.
In a DCF, you should count SBC as a real cash expense or, if you count it as a non-cash add-back, you should reflect the additional shares by increasing the company’s diluted share count, which will reduce the Implied Share Price.
Most DCFs get this completely wrong because they use neither approach: They pretend that SBC is a normal non-cash charge that makes no impact on the share count (wrong!).
What’s the proper tax rate to use when calculating FCF – the effective tax rate, the statutory tax rate, or the cash tax rate?
The company’s Free Cash Flows should reflect the cash taxes it pays.
So, it doesn’t matter which rate you use as long as the cash taxes are correct.
For example, you could use the company’s effective tax rate (Income Statement Taxes / Pre-Tax Income), and then include Deferred Taxes within the non-cash adjustments.
Or you could calculate and use the company’s “cash tax rate” and skip the Deferred Tax adjustments.
You could even use the statutory tax rate and make adjustments for state/local taxes and other items to arrive at the company’s real cash taxes
It’s most common to use the effective tax rate and then adjust for Deferred Taxes based on historical trends.
How should CapEx and Depreciation change within the explicit forecast period?
Just like the company’s Free Cash Flow growth rate should decline in the explicit forecast period, the company’s CapEx and Depreciation should also decline.
High-growth companies tend to spend more on Capital Expenditures to support their growth, but this spending declines over time as the companies move from “growth” to “maintenance.”
If the company’s FCF is growing, CapEx should always exceed Depreciation, but there may be less of a difference by the end.
Also, if the company’s FCF is growing, CapEx should not equal Depreciation – even in the Terminal Period.
That’s partially due to inflation (capital assets purchased 5-10 years ago cost less), and partially because Net PP&E must keep growing to support FCF Growth in the Terminal Period.
If you’re assuming that the company’s FCF stagnates or declines, then you might use different assumptions.
Should you reflect inflation in the FCF projections?
In most cases, no. Clients and investors tend to think in nominal terms, and assumptions for prices and salaries tend to be based on nominal figures.
If you reflect inflation, then you also need to forecast inflation far into the future and adjust all figures in your analysis.
That’s rarely worthwhile because of the uncertainty, extra work, and extra explanations required.
If the company’s capital structure is expected to change, how do you reflect it in FCF?
You’ll reflect it directly in a Levered DCF because the company’s Net Interest Expense and Debt principal will change over time. You’ll also change the Cost of Equity over time to reflect this.
The changing capital structure won’t show up explicitly in Unlevered FCF, but you will still reflect it in the analysis with the Discount Rate – WACC will change as the company’s Debt and Equity levels change.
What’s the relationship between including an income or expense line item in FCF and the Implied Equity Value calculation at the end of the DCF?
If you include an income or expense line item in Free Cash Flow, then you should exclude the corresponding Asset or Liability when moving from Implied Enterprise Value to Implied Equity Value at the end (and vice versa for items you exclude).
For example, if you capitalize the company’s operating leases and count them as a Debt-like item at the end, then you should exclude the rental expense from FCF, making it higher.
This rule also explains why you factor in Cash and Debt when moving to the Implied Equity Value in an Unlevered DCF: You’ve excluded the corresponding items on the Income Statement (Interest Income and Interest Expense).
How do Net Operating Losses (NOLs) factor into Free Cash Flow?
You could set up an NOL schedule and apply the NOLs to reduce the company’s cash taxes, also factoring in NOL accruals if the company earns negative Pre-Tax Income.
If you do this, then you don’t need to count the NOLs in the Implied Enterprise Value Implied Equity Value calculation at the end.
However, it’s far easier to skip that separate schedule and add NOLs as a non-core-business Asset in this calculation at the end.
Beyond the extra work, one problem with the first approach is that the company may not use all of its NOLs by the end of the explicit forecast period!
Should you ever include items such as asset sales, impairments, or acquisitions in FCF?
For the most part, no. You certainly shouldn’t make speculative projections for these items – they are all non-recurring.
If a company has announced plans to sell an asset, make an acquisition, or record a write-down in the near future, then you might factor it into FCF for that year.
And if it’s an acquisition or divestiture, you’ll have to adjust FCF to reflect the cash spent or received, and you’ll have to change the company’s cash flow after the deal takes place.
What does the Cost of Equity mean intuitively?
It tells you the average percentage a company’s stock “should” return each year, over the very long term, factoring in both stock-price appreciation and dividends.
In a valuation, it represents the percentage an Equity investor might earn each year (averaged over decades).
To a company, the Cost of Equity represents the cost of funding its operations by issuing additional shares to investors.
The company “pays for” Equity via potential Dividends (a real cash expense) and also by diluting existing investors (thereby giving up stock-price appreciation potential)
What does WACC mean intuitively
WACC is similar to Cost of Equity, but it’s the expected annual return if you invest proportionately in all parts of the company’s capital structure – Debt, Equity, Preferred Stock, and anything else it has.
To a company, WACC represents the cost of funding its operations by using all its sources of capital and keeping its capital structure percentages the same over time.
Investors might invest in a company if their expected IRR exceeds WACC, and a company might decide to fund a new project, acquisition, or expansion if its expected IRR exceeds WACC.
How do you calculate Cost of Equity?
Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta
The Risk-Free Rate represents what you would earn on “risk-free” government bonds denominated in the same currency as the company’s cash flows. You usually use 10-year or 20year bonds to match the explicit forecast period of the DCF.
Levered Beta represents how volatile this stock is relative to the market as a whole, factoring in both intrinsic business risk and risk from leverage.
And the Equity Risk Premium represents how much the stock market in the company’s country will return above the “risk-free” government bond in the long term.
Stocks are riskier and have higher potential returns than government bonds, so you take the rate of return on those government bonds, add the extra returns you could get from the stock market, and then adjust for this company’s specific risk and potential returns.
If a company operates in the EU, U.S., and U.K., what should you use for its Risk-Free Rate?
You should use the rate on the government bonds denominated in the currency of the company’s cash flows.
So, if the company reports its financials in USD, you might use the 10-year U.S. Treasury Rate; if it reports them in EUR or GBP, you might use the rate on 10-year bonds issued by the European Central Bank or the Bank of England.
What should you use for the Risk-Free Rate if government bonds in the country are NOT risk-free (e.g., Greece)?
One option is to take the Risk-Free Rate in a country that is “risk-free,” like the U.S. or U.K., and then add a default spread based on your country’s credit rating.
For example, you might start with a rate of 2.5% for 10-year U.S. Treasuries and then add a spread of 11.2% for Greece based on its current credit rating.
That rate of 13.7% represents how yields are much higher in Greece due to the significant chance of government default.
How do you calculate the Equity Risk Premium?
Stock-market returns differ based on the period and whether you use an arithmetic mean, a geometric mean, or other approaches, so there’s no universal method.
Many firms use a publication called “Ibbotson’s” that publishes Equity Risk Premium data for companies of different sizes in different industries each year; some academic sources also track and report this data.
You could also take the historical data for the U.S. stock market and add a premium based on the default spread of your country/market.
For example, if the historical U.S. premium is 7%, you might add 3% to it if your country’s credit rating is Ba2, and that rating corresponds to a 3% spread.
Finally, some groups use a “standard number” for each market, such as 5-6% in developed countries
How do you calculate the Equity Risk Premium for a multinational company that operates in many different geographies?
You might take the percentage revenue earned in each country, multiply it by the ERP in that market, and then add up everything to get the weighted average ERP.
To calculate the ERP in each market, you might use one of the methods described in the previous question. The “Historical U.S. stock market returns + default spread” approach is common here.
What does Beta mean intuitively?
Levered Beta tells you how volatile a company’s stock price is relative to the stock market as a whole, factoring in both intrinsic business risk and risk from leverage (i.e., Debt).
If Beta is 1.0, when the market goes up 10%, this company’s stock price also goes up by 10%.
If Beta is 2.0, when the market goes up 10%, this company’s stock price goes up by 20%.
Unlevered Beta excludes the risk from leverage and reflects only the intrinsic business risk, so it’s always less than or equal to Levered Beta
Could Beta ever be negative
Yes, it’s possible. The company’s stock price must move in the opposite direction of the entire market for Beta to be negative.
Gold is commonly cited as an Asset that has a negative Beta because it often performs better when the stock market declines, and it acts as a “hedge” against disastrous macroeconomic events.
However, negative Betas for companies are quite rare and usually revert to positive figures, even if they’re negative for short periods.
Why do you have to un-lever and re-lever Beta when calculating the Cost of Equity?
You don’t “have to” un-lever and re-lever Beta: You could just use the company’s historical Beta, i.e., its own Levered Beta, and skip this step.
But in a valuation, you’re estimating the company’s Implied Value – what it should be worth.
The historical Beta corresponds more closely to the company’s Current Value – what the market says it’s worth today.
By un-levering Beta for each comparable company, you isolate each company’s inherent business risk.
Each company might have a different capital structure, so it’s important to remove the risk from leverage and isolate just the inherent business risk.
You then take the median Unlevered Beta from these companies and re-lever it based on the capital structure (targeted or actual) of the company you’re valuing.
You do this because there will always be business risk and risk from leverage, so you need to reflect both for the company you’re valuing.
You can think of the result – Re-Levered Beta – as: “What the volatility of this company’s stock price, relative to the market as a whole, should be, based on the median business risk of its peer companies and this company’s capital structure.
What are the formulas for un-levering and re-levering Beta, and what do they mean?
Assuming the company has only Equity and Debt:
Unlevered Beta = Levered Beta / (1 + Debt / Equity Ratio * (1 – Tax Rate))
Levered Beta = Unlevered Beta * (1 + Debt / Equity Ratio * (1 – Tax Rate))
If the company has Preferred Stock, you add another term for the Preferred / Equity Ratio.
You use a “1 +” in front of Debt / Equity Ratio * (1 – Tax Rate) to ensure that Unlevered Beta is always less than or equal to Levered Beta.
And you multiply the Debt / Equity Ratio by (1 – Tax Rate) because the tax-deductibility of interest reduces the risk of Debt.
The formulas reduce Levered Beta to represent the removal of risk from leverage, but they increase Unlevered Beta to represent the addition of risk from leverage.
