General Flashcards
Why is early-stage companies often difficult to valuate?
- Will often have negative CF’s in the first years.
- First years are driven by high uncertainty.
- What is comparables?
- the use of similar characteristics between companies.
- We look at characteristics that are driven by other underlying attributes.
- What will the use of Comparables give us?
A quick and easy “ground”.
- What are some of the problems with comparables with private firms?
- Don’t know what valuation methods other firms have done
- Their valuation is driven by private info (accounting and other key performance info), so can be har to find key ratios
- Valuation Methods
- Private Info
- What are some typical multiples for public firms?
P/E-ratio
Market value of Equity divided by total revenue
Market value of Equity divided by shareholders Equity on balance sheet (market-to-book ratio)
What is P/E-ratio and how can it be misleading when two companies have similar characteristics, but different capital structure?
- Price/Earnings
- Shows Profit after Tax
- Different Cap Structure = Different Tax
- Use EBIT instead of EBITDA
- EBIT ignores the Tax Interest
- Typical comparables for Internet business
Subscribers
- Typical comparables for biotech company
Number of patents awarded
- Typical comparables for gold searching company
Number of ounces of gold
- IPO
Initial Public Offering.
- Offering shares of a pricate company to the public in a new stock issuance
- Industry-specific versus accounting-based multiples in offering prices for IPO, whats best?
Research show that industry-specific multiples gives a stronger explanatory power.
Accounting-based gives little predictive ability
- Why is accounting-based multiples often little predictive for young, publicity traded firms?
- Uncertainty (start-ups)
- Accounting-based multiples vary
- How to avoid double-counting tax shields in the NPV method
- With NPV: Do not deduct Interest Payments from the Cash Flows
- What is the Terminal Value (TV)?
A company’s (or project, asset etc.) value into infinity
- E.g., sets an infinite growth rate after the forecasted period
- What to do when there are no comparable firms in terms of finding beta?
Use common sense. See whether the risk is systematic or if it can be diversified away.
Other option is to calculate “earnings betas” if accounting data is available.
- How to calculate earnings beta?
Comparing a private company’s net income to a stock market index such as S&P 500. Then use OLS to find the beta (the line).
- NPV method: A valid comparable company should have similar ___
Similar financial performance,
growth prospects,
operating characteristics to the company being valued.
- Is beta a proper measure for firm risk?
Numerous studies have showed that firm size or ratio of book-to-market equity values may be more appropriate.
- What is Monte Carlo Simulation
Monte Carlo simulation is a method used to measure different probabilities based on different outcomes:
- Considers all different possible combinations given your inputs
- Gives you a set of different probabilities for the different outcomes
- Nice to look at to find the impact of risk
- What is Net Operating Loss (NOL)
- Expenses higher than Income
- Deductions higher than Taxable Income
Generally used to allow some form of Tax Relief:
- Can reduce a company’s future tax liability: offset a company’s tax payments in some periods that can be carried years ahead
- APV Valuation three steps
1) CFs are valued under the assumption of 100% Equity (ignoring the Capital Structure)
2) Quantify the Tax Benefits
3) Quantify the NOLs
- What is Leverage Buyouts
“Using assets from target company to fund the acquisition”
- A buys B, by using assets from Firm B as a part of the loan
- Can allow for large acquisitions, sometimes Hostile Takeovers, with great risk
- Leads to high amounts of leverage, which hopefully gets reduced.
- Differences between NPV and APV.
APV is the NPV if 100% equity financed + the PV of financial benefits.
APV splits into different components
- What is Venture Capital
- Type of Private Equity Financing
- Gives Funds to start-ups, early-stage firms with high growth potential
- Generally rich investors, Investment Banks …..
- Does not need to be monetary; also expertise in technical or managerial
- What is Dilution? What happens?
- Existing shareholders equity position gets reduced due to a new issuance or creation of new shares.
- Existing shareholders gets a smaller % ownership.
- Because there are more shares, the stock price will drop.
- Venture Capital Method: What is the Target Rate of Return?
- The Yield the Venture Capitalist feels is required to justify the risk and effort of the investment
- What is the Venture Capital Method?
- Most common method in VC industry
- Investors will seek a high return; VC methods incorporates this and uses an appropriate discount rate (high)
- Market multiples most common method to find Terminal Value
- Target Rate of Return
How its calculated
- The yield the Venture Capitalists feels will justify he’s effort, risk, and investment
Investment/Discounted Target Value
- Difference in marketable: public stock vs. private firms
• Equity of Private Firms often less marketable than Public Stocks
- So Investors will demand a higher return
- Why does Venture Capital Method have such a large discount rate? Criticism + +
- Large Discount Rate to compensate for the great risk.
Venture capitalists justifies it by saying that its a compensation for:
- illiquid firms
- Their valuable Equity and Time
- Entrepreneurs have overly optimistic projections.
- Option Analysis for Venture Capitalists
• When the VC has “Flexibility” • For example: - Increase/Decrease production - Abandon - "follow-up" investments. Motivate Entrepreneur. Like a Call Option
- What model can be used in valuing firms as options?
Black-Scholes model
- Biggest strength of using option pricing to Value Investment Opportunities
“Flexibility”. Wait and see, learn more about the project.
- Concerns about Option Pricing to Value Investment opportunities?
1) Not a well known and used method. Might be hard to convince.
2) Hard to price Real World problems
3) Maybe it cannot be priced in Black-Scholes
- Comparables strengths
- Quick to use
- Simple to understand
- Commonly used in industry
Quick, Simple, Common
- Comparables weaknesses
For Private Companies:
- Accounting (rules, depreciation, private info)
- Hard to find (private)
- Need to Adjust; take their illiquidity into account
- NPV Strengths
• Theoretically Sound
- NPV Weaknesses
• CFs hard to estimate
- Startups
• Private company comparables might be hard to find
- WACC assumes constant Capital Structure
- WACC assumes constant effective tax
- APV Strengths (when is it suitable)
- Theoretically Sound
- Suitable where the capital structure is changing (leverage buyouts for example)
- Suitable where the effective tax rate is changing (e.g., when there are NOLs)
- APV Weaknesses
- More complicated than NPV
* Same disadvantages as NPV, except that it overcomes the constant assumptions in NPV
- Venture Capital Strengths
- Simple and Quick to use.
* Very common method
- Venture Capital Weaknesses
- Relies on Terminal Values derived from other methods
* Oversimplified
- Asset Options Strengths
- Theoretically Sound
* Overcomes drawbacks from NPV and APV where managers have flexibility
- Asset Options Weakness
- Not commonly used in industry, may not be understood
- Real world situations difficult to price in “options”
- Limitations on Black-Scholes model
What is a venture capital fund
A Private investment fund that buys firms with high growth potential, for future high returns
Which type of investors does a venture capital fund typically target?
For institutional investors; retail investors are not solicited … but can include High Net worth Individuals… Family « office » Angels
Institutional investors are…
Endowment funds
Pension funds
In the past, VC funds solicited commercial banks or investment banks but they no longer do so because it is too risky for commercial banks
Why do VC funds exclude retail investors?
Because they solicite investors directly on a one on one basis. VC investments do not have a risk profile that is appropriate for retail investos
What type of investment is VC?
VC funds are
« alternative investments »
And sometimes regrouped with private equity, real estate, hedge funds, real assets…
typically targets start ups and tech companies
PE targets more well established companies that already have cash flows but need more financing
In what type of companies do VC funds invest?
private companies:
- high growth potential
- innovative companies
What management style do venture capitalist have?
Management Style:
- Active investors
- Manage company’s as they manage investments
- Not a Liquid investment (yet), so involved in the company for years.
Liquid versus illiquid investment
VC investments is not liquid investments
Traditional investments are liquid, hence you dont need to be active since you can leave the investment when you want
Why do they demand high returns?
High risk
How are the returns realized?
- Bringing companies in to the market through an IPO
- Selling companies they invest in
Invest - Monitor - Exit
What role do VC funds play in the finance industry?
- VC brings up new high growth innovative companies
- Commercial Banks do not lend that much money to these Companys. They lend to companies that have assets to put into collateral and somewhat stable cash flows
VC Firms
funds themselves
Limited Partnership (LP)
contract between the LPs and the fund
LP (Limited Partners)
investors
GP (General Partners)
fund managers
Early-Stage Fund
start ups
Late-Stage Fund
more stable companies that are still a bit young
Management Fee
fees payed for the GP’s job (typically 2%)
How is value « created »?
Invest in company will grow in value because of its cash flows
When the company has a competitive edge over other companies, it can generate more cash flows
How do we recognize value creation in investments in general?
with a model based on forecasts : DCF
How is risk accounted for in the valuation of investments?
in the discount rate. we chose the discount rate based on the risk of the investments
What are « Value Drivers » according to KOLLER et. al.?
- Growth potential for a long period of time
- potential to realize high net margin based on their competitive edge, which gives it a capacity to finance its growth internally.
Book-to-Market Ratio
- Compares a firm’s book value to its market value
- Market Value of Equity divided by shareholders Equity on balance sheet
How can dilution happen?
1) Company issues new shares
2) Existing holders wants to exercise options, warrants.
NPV, APV, different Assumptions
- WACC assumes constant Capital Structure
* WACC assumes constant effective tax
