Corporate Finance theory + valuation methods Flashcards
Explain present value
- present value: based on the idea that a dollar in the present is worth more than a dollar in the future due to the time value of money
- this is bcuz of potential to earn interest by investing it today
- Present V (t=0) = Cash Flow (t=1)/ (1+r)^t=1
how is present value linked to valuation of a company
- for intrinsic methods like DCF, value of a company will be equal to the net present value of all future cash flows it generates
- hence a company with high valuations would imply it received high returns on the capital invested, and has high positive net present value, as well as low risk associated with its cash flow
what is equity value and how is it calculated?
- equity value and Market cap are the same thing
- equity value is the company’s value to its shareholders
- calculated by: closing share proce * total diluted shares outstanding
What is enterprise value and how do you calculate it
- Enterprise Value (EV) represents the value of the operations of a company to all shareholders, which includes common shareholders, preferred shareholders and debt lenders.
- Enterprise Value (EV) is a measure of a company’s total value, often considered more comprehensive than market capitalization alone.
- Theoretical cost to acquire the entire business, including its debt and cash positions.
- EV is widely used in financial analysis, especially in valuation multiples like EV/EBITDA, to compare companies regardless of their capital structures
- EV caluclated = company’s equity value + net debt + preferred stock + minority interest
how to calculate the fully diluted number of shares outstanding?
- treasury stock method
- take basic share count + dilutive effect of options and other dilutive securities
-Determine the number of options or warrants outstanding and the exercise price of each. - Calculate how many shares would be issued if all options/warrants were exercised.
- Calculate the cash proceeds the company would receive from the exercise of these options/warrants.
- Determine how many shares the company could buy back at the current market price using those proceeds.
- Add the net increase in shares (new shares issued minus shares repurchased) to the basic shares outstanding.
how to calculate equity value from enterprise value
- equity value = enterprise value - net debt - preferred stock - minority interest
which line items are included in the calculations of net debt
- net debt accounts all interest bearing debt, so both long and short term debt + bonds + preferred stock and non-controlling interests
- net debt = total debt - cash & equivalents (short term/equity investment)
when calculating EV, why do we add net debt to market cap
- market cap alone only accounts for company equity and not debt and cash holdings
- and during valuation for acquisition the acquirer takes over both the equity and the liabilities
- Debt: Represents obligations that a potential buyer would need to assume or pay off.
- Cash: Represents liquid assets that can be used to reduce the effective cost of acquisition.
what is adjusted when u add net debt to market cap
- adding debt increases EV
- subtract cash: decreases EV, cuz company cash offsets purchase costs
why use net debt instead of gross debt
- gross debt - cash = net debt
- cash can payoff/cancel out debt
- more realistic assessment: company can use cash reserve to pay down debt
- more comparable which has varying levels of cash and debt
- leverage ratios: financial ratios like Debt/EBITDA use net debt to provide clearer picture of leverage
compare equity and enterprise value
Equity Value: value of company equity shares. Share Price * Outstanding Shares, Equity Shareholders, Dependent on cpaital structure + market fluctuations
EV: Total value of company for all stakeholders, Equity Value + net Debt + preferred stocks + Minority Interest. All stakeholders (equity, debt, preferred shareholders), neutral to capital structure, more comprehensive
different multiples used for EV and equity value
- Equity Value: fundamental component in valuation ratios like Price-to-Earnings (P/E) and Price-to-Book (P/B) ratios
- Commonly used in ratios like EV/EBITDA, EV/Sales, and EV/EBIT, which are preferred over equity-based multiples for their comprehensive perspective
zoom vs airlines example for enterprise and equity
- capital structure differences: airlines have high debt due to capital intensive nature of industry (high cap ex). Zoom: operated w lower debt levl and high cash reserves
- Equity V Perspective: Zoom: high market cap cuz increase demand for video conferences. Airlines: lower market cap due to covid setbacks
- EV perspective: Airlines: despite lower market cap high debt level increase EV, zoom: lower debt and high cash reserve, so more balances EV towards equity value
can a company have a negative net debt balance and have an enterprise value lower than its equity value?
- net debt j mean company has more cash than debt
- i.e microsoft and apple have nuge negative net debt
- EV represents value of company’s operations which doesnt include non-operating assets like cash
can EV of a company turn negative
very rare but yes, but it j means that a ngeative enterprise value means the net cash balance (cash is a lot bigger than debt)»_space;»> equity value
If a company raises 250M in additional debt, how does its EV changes
- theoretically no impact, bcuz EV is neutral capital structure
- new debt raised bcuz cash and debt balance would increase and offset each other
- however, the cost of financing (like fees and interest expense) could lead to lower valuation from higher cost of debt
what is minority interest
it is the proportion of a subsidiary company in which the parent company doesn’t own
1. Under US GAAP as long as main company has >50% of subsidiary company but beloow 100% (non-controlling investment
2. it must include 100% of the subsidiary’s financials in their statements even they dont own 100%
3. this becomes a problem when calculating multiples bcuz the EV/EBITDA would include the subsidiary’s EV too and we don’t want that
how do we include minority interest to equity value in the calculation of enterprise value
- when we use multiples like EV/EBITDA
- EBITDA reflects 100% of subsidiary’s earnings
- but EV only reflect the portion of subsidiary that the parent owns
- hence for more comprehensive comparison, we need to add the minority interest you add in the 100% subsidiary and align the EV and EBITDA
what are 2 main approaches to valuations
- Intrinsic valuation: looking at the internal business, and its ability to generate cash flows. DCFs is most common type of intrinsic valuation, it is based on the notion that a business value = present value of its future free cash flows
- Relative Valuation: looking at comparable company’s multiples and applying average or median multiples derived from the ;eer group, often EV/EBITDA, P/E. Trading comps look at public companies current market value, and transaction comps look at comparable companies at the multiples it was acquired at
Trading comps
looking at values of multiples for publicly traded companies, and look at their current market value
transaction comps
based on recent or previous acquisition prices and multiples of similar sector.
can be adjusted
discounted cash flow
DCF its value = the present value of its projected cash flows, discounted at an approapriate rate that reflects the risk of those cash flows
LBO
potential acquisition target under highly leveraged scenario to determine the max purchase price
what type of valuation yields highest valuation
- transaction comps, bcuz they include a premium, most premiums are somewhere around 25-50% above market price to account for synergies
- hence multiples derived from this is higher value than trading comps or DCF
which valuation has most assumptions/variable
- DCF because it is based on forward looking projections and assumptions such as risk
- relative valuation is based on actual prices which are paid for or actual prices a company is on the market, hence less deviation
DCF vs trading comps
- DCF Ad: based on intrinsic value and fundamental financials of a company, independent of market
- DCF dis: sensitive to assumptions, is forecast period is long (can be quite unpredictable and challenging to predict), terminal value comprises 3/4s of the implied valuation which may be inaccurate
- comps Ad: market value of business, actual deals
- comps disad: very few accurate comparables (no exact company is the same), vulnerable to market conditions and not the company itsefl, implicit assumptions
how to determine which valuation method
- use all three/combination
- arrive at a more defensible approximation
- DCF ad trading comps can be used together to compliment each other, give a market based and intrinsic sanity check
- look at how far a DCF is compared to market prices
Would you agree with the statement that relative valuation relies less on the discretionary assumptions of individuals?
No, because there is also assumptions for relative valuation, just not made by you, but made by others in the market.
Market is inefficient
what is FCF
- free cash flow: cash flow remaining after accounting for recurring expenditures to continue operating
- FCF = cash from operations - capex
why are periodic acquisitions excluded in FCF calculation
- inflows and outflows of cash which are recurring an operational
- periodic acquisition is one-time and unpredictable event, whereas Capex is recurring
difference between unlevered and levered FCF
- unlevered FCF is cash flow a company generated after accounting for all operating expenses and investments
- FCFF = EBIT * (1-tax rate) + D&A - changes in NWC - CapeX
- levered FCF: cash flow after payment to lenders since interest expense and debt payments r deducted
- FCFE = cash from oper - capex 0 debt principle payments
Let’s say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $5 each – what is its fully diluted equity value?
- 100 * 10 = 1000 dollars
- 10 shares * 5 = 50 dollards
- 50 dollars can buy back 5 shares at 10dollar/share
- hence 100 + 5 = 105 shares diluted, and 1050dollars
Could a company have a negative Enterprise Value? What would that mean?
- EV = market cap + debt - cash + minority interest + preferred shares
- so either market cap is rlly low
- or net debt is negative, meaning cash is VERY positive
why add preferred stock to enterprise value
- preferredn stock pays out a fixed dividend, and have higher claim to company assets than equity investors
- seen as a debt
How do you account for convertible bonds in the Enterprise Value formula?
If the convertible bonds are in-the-money, meaning that the conversion price of the bonds is below the current share price, then you count them as additional dilution to the Equity Value; if they’re out-of-the-money then you count the face value of the convertibles as part of the company’s Debt.
Are there any problems with the Enterprise Value formula you just gave me?
- yes there are more things to add into the formular
- net operating losses shoudl be treated equal to cash
- investments should be treated as cash
- capital leases should be counted as debt
- any other leases or obligations should be counted as debt
EV = equity value - cash + debt + minority interest + preferred stock - NOLs - Investments + capital leases + other obligations (pensions)
Should you use the book value or market value of each item when calculating Enterprise Value?
- technically should always use market value, but difficult to get market value for some items in the EV
- so only use market value for equity value and the rest is from balance sheet
What percentage dilution in Equity Value is “too high?”
anything over 10% is odd
rank 3 valuation method
- precedent transaction: has control premiums (but this also varies, cuz financial sponsors less likely to pay a lot of control premium
- DCF has a lot of variables to it, so it can be high or low. often bullish because assumes optimism in future cash flow, sensitive to small assumptions
- trading comps: public companies, reflect market conditions
when would u not use DCF in valuation
- unpredictable cash flow or a high growth potential such as tech or biotech, and in this case its difficult to project its future cash flows
- or a company which isnt expected to grow, or a downhill company because its hard to predict if there will be a turnaround in cashflow, altho u could use a DCF it would be less certain
other methodologies?
- liquidation caluation: if a company went bankrupt and needs ro liquidate its asset to see how much capital for equity investors
- replacement value - value company based on the cots of replacing its assets
- LBO: determining how much a PE firm should pay for a company to have a good IRR (20-25%) and how much leverage to use
- sum of parts: when dealing w big conglomerates w very different operating divisions, need to value each division separately
- future share price analysis: projecting company share price based on P/E multuples of public companh comparables and discounting it to present value
What are the most common multiples used in Valuation?
- EV/Revenue, EV/EBITDA, EV/EBITD, P/E (sahre price/Earnings per share), and P/BV (share price/Book value)
industry specific multiples
tech: EV/pageviews
retail arilins: EV/EBITDAR rent differs hugely depending on company
why do you use EV based and not equity value based multiples?
- if what u are looking at applies to all investors then use EV
- if it only applies to equity shareholders then can use equity value
would LBO or DCF give higher valuation
- LBO you only get value from the company when you sell it and hence when you reach at the terminal value
- DCF accounts for both company cash flows and the terminal value
Unlike a DCF, an LBO model by itself does not give a specific valuation. Instead, you set a desired IRR and determine how much you could pay for the company (the valuation) based on that.
How would you present these Valuation methodologies to a company or its investors?
Usually you use a “football field” chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number.
how to value an apple tree
- relative valuation (comparable or precedent transactions)
- value of apple trees cash flow (how much cash flow it generates) DCF
When would a Liquidation Valuation produce the highest value?
- unusual because usually liquidation is for companies which are going bamkrupt hence wont be worth a lot
- but its when company has substatial hard assets like a lot of PP&E, and the market is undervalueing it by a lot
What would you use in conjunction with Free Cash Flow multiples – Equity Value or Enterprise Value?
- levered free cash flow (cash flow straight from operations w no financing done to it, interest included alr) = hence only applies to equity shareholders, use equity value
- unlevered free cash flow has interests alr paid to debt investors, hence use EV
when would u use EV/Revenue
- when loss making company
- use equity/revenue when enterprise is negative
how to select comparables or precedent trasactions
- industry
- finanicla criteria (revenue, EBITDA) - revnue over 100mill
- geography
- time - in the past 2 years
How do you apply the 3 valuation methodologies to actually get a value for thecompany you’re looking at?
- get a set of multiples from a set of valuation methods/comparables, multiply it sby the relevant metric (i.e their EBITDAmltiple is 8x and their EBITDA is 500M, my implied EV would be 4B
- football field graph looks at minimum, maximum, 25th, median, 75th percentile
Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium?
- its stock price went up
- IP or key patent (not shown on financials)
- market leader and has greater market share