Picasso - Valuation Flashcards
What is a valuation?
Find the intrinsic value of or what someone else would pay for the asset
What are the four main valuation methodologies?
1+2) Multiple = relative valuation = value / metric of cash flow generation
1) Comps - peer group, pick a median / mean of a multiple, and apply to your company’s cash flow
- Apply 10-40% discount to private companies as a liquidity discount
2) Precedents - M&A in space / among peers. What did others pay for businesses similar to the target?
3) DCF - value of bus = PV of its future cash flows discounted at its WACC
4) LBO - value a sponsor would pay given a certain cost of equity capital. Helps determine debt capacity as well.
What are the four main valuation methodologies?
1+2) Multiple = relative valuation = value / metric of cash flow generation
1) Comps - peer group, pick a median / mean of a multiple, and apply to your company’s cash flow
- Apply 10-40% discount to private companies as a liquidity discount
2) Precedents - M&A in space / among peers. What did others pay for businesses similar to the target?
3) DCF - value of bus = PV of its future cash flows discounted at its WACC
4) LBO - value a sponsor would pay given a certain cost of equity capital. Helps determine debt capacity as well.
Discuss why one technique may be a more accurate assessment of value than another?
Depends.
1) Comps - primarily used for IPOs
- Pros: similar peers (industry, size, capital structure), efficient market, adequate public disclosure
- Cons: what if no peers? Private? Thinly traded? Market valuation may be off.
2) Precedents - similar pros and cons
- Pros: spot industry consolidation trends
- Market cycles: what if M&A market over last 2 years does not represent condition today? March 2020
3) DCF
- Pros: precise (but not always accurate), meaning if you have clarity on revenue and expenses, you can more accurately calc value; good when relative valuation not available
- Cons: garbage in, garbage out; majority of value may be from terminal value; how do you quantify risk in the WACC?
4) LBO
- Pros: good if you want to find a floor valuation; stress test model and debt capacity
- Cons: assuming an exit; not always applicable to strategics/parties that don’t use as much leverage/go after synergies; garbage in garbage out
Of the four main valuation methodologies, which ones are likely to result in higher/lower value?
Depends.
1) Precedents - synergies, control premium
2) DCF (maybe) - equity analysts more optimistic if you are using consensus forecasts
3) Comps - depends where comps are trading and which comps you pick. No control premium / synergies
4) LBO - floor valuation, higher cost of capital than a DCF
How do you use the three main valuation methodologies to conclude value?
- Use a valuation range for each of the three and “triangulate” the three ranges to conclude a valuation range.
- Relative valuation = multiple of a metric
- DCF = discount future cash flows to today
- Depending on availability of information, comps set, confidence in forecasts, I may weigh one method over another
How do you determine which valuation method to use?
Depends on the information you have, peer set, situation, confidence in forecasts, buyers involved
What are some other possible valuation methodologies in addition to the main three?
- Sum of parts analysis
- Net asset value
- Replacement cost
- Liquidation analysis
- Get creative with comps
When would you use a sum-of-the-parts valuation?
- Company with unrelated** divisions
- Each has its own comp set / drivers of value
- GE: precedent transactions for Baker Huges; comps for GE Finance
When would you use liquidation valuation?
- Compare to going concern valuation
- Evaluate downside
- Distressed debt/special sits investor
What are some common valuation metrics?
Above the line
- EV / EBITDA (EBIT, Sales)
- EV / Reserves; EV / Clicks; EV / Stores
Below the line
- P/E; P/LFCF; P/B
What is a PE ratio and why do analysts use it?
Price / EPS
- How is the market valuing this company’s earnings
- Incoporate expectations of growth, risk, future cash flows
PEG to see how much companies are paying for growht
What is the calculation for EPS?
NI available to common (NI less preferred dividends) / number of shares
Does preferred stock trade at a discount or premium to common stock and why? Convertibles?
If distressed, Premium. Liquidation preference over common.
But there’s a cap on the PS upside. Common gets the residual value, so common will trade above for high growth companies
Premium - pay for the optionality
Why can’t you use EV/Earnings or Price/EBITDA as valuation metrics?
Capital structure inconsistencies
- EV looks at the value of the entire enterprise to all stakeholders, while earnings looks at the earnings after debt holders have been paid off. Correct would be EV / EBIT
What options would you consider to raise a depressed stock price?
- Recapitalize
- Buy back shares; issue dividends to send positive signal
- Accretive M&A; expand into high growth market
- Mgmt comp in stock options
What is the difference between enterprise value and equity value?
Net debt.
EV looks at value of enterprise to all stakeholders
Equity value looks at the residual value after debtholders have been paid off
What is Enterprise Value? What is the formula?
Value of the operations attributable to all providers of capital.
Net debt + market cap + NCI + Preferred stock + Off balance sheet liabilities
How do you calculate the market value of equity?
FDSO * share price
How do you calculate free cash flow to the firm? To equity?
FCFF = EBIT - taxes + D&A - ch NWC - Capex FCFE = NI + D&A - Ch NWC - Capex (diff is after-tax interest) - mandatory debt payments
What is FCF?
Cash flow available to all stakeholders.
- Cash company can use to pursue M&A, growth capex, pay down debt
How do you calculate FCF from net income?
(NI + interest*(1-T)) + D&A - NWC and Capex
- Add back interest but you don’t get the whole benefit due to the addt’l taxes you must pay
How do you get from EBITDA to unlevered free cash flow?
Taxes, NWC, Capex
What are three pit falls of the WACC method?
- Assumes a constant capital structure
- CAPM - Beta not a perfect measure. Discretion ove r MRP
3) Cost of debt - may change over time. Not flexible
What is the Adjusted Present Value method?
PV of tax benefit plus PV of CFs assuming all equity financed
- Discount UFCF using the discount rate of an unleverd firm
- PV of tax shield = rDTD/rd (perpetuity) = T*D
- Sum
DTS = amount of company a company saves by not having to pay taxes on its debt
What is the difference between the APV and WACC methods?
APVs useful for LBOs
WACC incorporates the effects of interest tax shields into the discount rate. Typically calculated from actual data from the balance sheet and used for a company with a consistent capital structure over the period of the valuation.
APV adds present value of financing effects to NPV assuming all-equity firm. Useful where costs of financing are complex and capital structure is changing. Use APV for LBOs. The primary shorting coming is that it is difficult to project the cost of financial distress
What is the difference between basic shares and fully diluted shares?
Basic = shares o/s today
Diluted = shares OS pro format for conversion of convertible debt/preferred stock; exercise of options
- Market implicitly uses diluted shares when looking at share price
What is Minority Interest and why do we add it in the Enterprise Value formula?
- Third party interest in a consolidated subsidiary
- Minority interest on the balance sheet
- Add it back because revenues and expenses are reported at 100% ownership; apples to apples
Subtracting cash from EV in an acquisition
Assuming that excess cash = total cash
- Buyer assumes cash on the balance sheet and can use that cash to reduce its effective purchase price
Subtracting cash from EV in an acquisition
Assuming that excess cash = total cash
- Buyer assumes cash on the balance sheet and can use that cash to reduce its effective purchase price
Walk me through a Discounted Cash Flow analysis.
- Financial forecast 5-10 years out in the future; calculate down to UFCF
- Terminal value (perpetuity growth or multiple of EBITDA / another metric)
- Calc your discount rate (WACC)
- NPV of Cash flows including terminal value = enterprise value
What is WACC and how do you calculate it?
Blended cost of capital required by debt and equity holders. Debt/value * rD * (1-T) + Equity/Value * rE
Capm = Rf + Beta * MRP
When is it not appropriate to use DCF analysis?
- Cannot quantify risk
- Not much confidence in the financial forecast
- Need an “objective” valuation
How do you calculate the cost of equity?
CAPM = rf + Beta*(rm-rf)
What is Beta?
Measure of systematic risk that explains the correlation between the stock price and the market
What effects does debt have on beta?
Debt increases financial leverage which makes equity earnings more volatile. Will increase beta
What is EBITDA?
Earnings before interest, taxes, depreciation and amortization.
Measure of operating cash flow available to all stakeholders
Unlevered beta –> levered
B(L) = B(U) (1+(1-T)(D/E))
Levered beta –> unlevered
B(U) = B(L) /[1+(1-T)*(D/E)]
How would you calculate the equity (levered) beta of a company?
Covariance of the stock returns versus the market, divided by the variance of the stock markets returns
You can also use comps
Regression of the stock vs the return of the market as a whole. Slope = beta
How do you calculate FCF?
EBIT*(1-T)+D&A-Taxes-NWC-Capex
When might you use the perpetuity growth method rather than the terminal multiple method?
- Poor comp set; not confident in the valuation multiple
- Believe your company will grow at a faster or slower growth rate than what is implied by the multiple.
- Normally, the multiple method is more appropriate as an objective measure
If you have two companies that are exactly the same (revenue, growth, risk, etc) but one is private and one is public, which company’s shares would be priced higher?
Public. As an equity holder, you value the liquidity of your position
Guide also notes transparency of reporting as a reason
If you have two companies that are exactly the same (revenue, growth, risk, etc) but one is private and one is public, which company’s shares would be priced higher?
Public. As an equity holder, you value the liquidity of your position
What kind of investment would have a negative beta?
Any asset’s price that is countercyclical
- Gold and precious metals
- Restructuring firms
Which is less expensive capital, debt or equity
Debt
- Seniority
- Interest tax deductible
Why do some stocks rise so much on the first day of trading and others don’t? How is that “money left on the table?”
- Depends on where the bookrunners price the stock
- Mr Market - can never guess for sure
- That is money that could have been raised for the company
- Short term valuation =/= long-term
- You want some “pop”
Why do some stocks rise so much on the first day of trading and others don’t? How is that “money left on the table?”
- Depends on where the bookrunners price the stock
- Mr Market - can never guess for sure
- That is money that could have been raised for the company
How do you calculate the WACC? CAPM?
WACC = D/VrD(1-T) + (E/V)*rE
CAPM = rF + B*(rM-rF)
What should you consider when using valuing an international company?
- Comp set
- Currency
- Correct discount rate
- Accounting rules (IFRS)
- Interest rates
- Currency risk, geopolitical risk, emerging market?
How do you select comparable companies and transactions?**
- Industry classification, financial criteria (EBITDA, size, financial profile), Geography, Product mix
- Id comps merger agreeemnts, 10Ks, equity research, trade reports, channel checks
- Look at merger activity of those comps
- Look at other mergers in the space
Company A is currently trading at a P/E ratio of 15x. It acquires a business with $10 million in EBITDA using 100% debt financing at a cost of debt of 10%. How much can it pay and still maintain its 15x P/E ratio?
PE = 1/15 = 6.6%
10% * (1-40%)=6%
invert the ratios again and think of it as an “equity earnings yield” vs a “cost of debt.” you are going to raise $1 of debt that costs you x and you will use that $1 of debt to acquire $1 of the target’s equity which will earn you y. if y>x, i.e., the acquired equity earns you more than the cost of the debt, then the deal is accretive.
10% interest rate after tax is 6.5%. for every $1 of debt you raise, you will pay $0.065 in interest. now compare that cost to the earnings generated by the target’s equity. invert the target PE of 10x and you get 1/10=10%. So every $1 of target equity acquired at 10x PE will generate $0.100 in earnings. So, if you raise a dollar of debt that costs you 6.5 cents and use the debt proceeds to buy a dollar of equity that will earn you 10 cents, your net result is positive 3.5 cents. Every dollar of the target’s equity that the acquirer buys using debt will increase the acquirer’s earnings by 3.5 cents. The acquirer’s equity share count is not changing because this is an all debt transaction, so earnings per share is increasing, i.e., the transaction is accretive to EPS.
Assume that subway tokens are $1.50 today and the price will go up to $2.00 tomorrow. How many tokens would you buy? (Silver Lake)
What’s the opportunity cost of capital?
10%
Current return = (2-1.5)/0.5=33%
= 3 years worth of 10% = (1+10%)^3
What does a multiple imply about your return? (Silver Lake)
Inverse to get your “earnings yield”
How do investment bankers increase net income through 1) Restructuring 2) M&A 3) Debt issuance 4) Equity?
1) Recapitalize the balance sheet - interest expense
2) Revenue and cost Synergies; you own the target’s economics
3) Refinancing; interest now deductible. What are you doing with the proceeds?
4) Recapitalize to take out interest expense. What are you doing with the proceeds?
What is working capital? How would you calculate it?
Cash tied up in the businss to run it. You need inventory on hand, customers don’t pay right away, and you accept trade on credit.
Also a measure of liquidity
Current assets less cash less current liabilities (accounting definition)
What happens to FCF if NWC increases?
Goes down. More cash tied up in business
How would you value a company with no revenue?
Multiple of page visits, reserves, or another metric of future cash flow generating ability
DCF but hard to forecast cash flows
Liquidation value of its assets on hand
How much would you pay for a company with $50 million in revenue and $5 million in profit?
10% margin
Need to know what other peers are trading at and what this company’s competitive positioning is. Industry, company, balance sheet, management, plan, risks. DCF?
Why do internet companies receive multibillion valuations when they have very low revenues?
Paying for growth
Assume that you use levered free cash flows rather than unlevered free cash flows. What is the effect? What discount rate should you use?
You calculate the equity value. Value will be lower than the unlevered FCF (enterprise value)
CAPM
Why would you not use DCF analysis for a bank or other financial institute?
Calculation of free cash flow is very different
- Use of interest in the business
( assets are loans and liabilities are operating related, part of its business)
- Working capital
Use dividend discount model
Why does Warren Buffett prefer EBIT multiples to EBITDA multiple?
Does the toothfairy pay for capex
What is a comparable set?
A comparable set lists financial data, valuation metrics and ratio analyses on a set of comparable companies in an industry. It is used to value private companies or better understand how the market values a particular industry.
Identify comparable companies using buiness and financial characteristics and then rank according to relevance (Tier I: Pure-play, Tier II: Relevant)
*Business characteristics: industry, products, customers, geography
*Financial characteristics: size, profitability, leverage
Why would a company with similar growth and profitability to its comps be valued at a premium?
- Intangible (brand name, management, quality of customers)
- Litigation for one company
- Size
- Technical selling (Mr Market)
- Capex / NWC needs
- Riskiness of the cash flows
Why are the PE multiples for a company in London different than that of the same company in the US?
- Different market (suppliers, end users, competitors, entrants, regulations)
- Different peer set
- S&P valuation vs British equivalent
When might you see Equity Value / Revenue?
It is rare. Sometimes large financial institutions with big cash balances have negative enterprise values. May also use for comparability of financial and non-financial institutes.
Why do we add preferred stock to the enterprise value of a company?
We are measuring the left hand side of the balance sheet (the true worth of the company) by summing up the dollar amount of capital provided
When might precedent transactions not produce a higher value than comparable companies?
- Mr. Market
- Down cycle
- Limited transactions / peer group
- Outliers
Which method of calculating TY value will result in a higher valuation?
- Depends on growth rate / discount rate / ebitda
When would liquidation valuation produce the highest value?
Going concern of the company less than liquidation.
- Suggests we should just shut it down
What is the debt tax shield? How is it calculated?
Tax savings associated with interest expense
PV of tax shield = rDTD/rd (perpetuity) = T*D
- Discount at a rate that captures the risk
What discount rate do you use for the APV method?
Discount as if an all equity financed firm
Why might there be multiple valuations for a single company?
Different opinions, comp sets, time periods, required rates of return on LBOs
What should you do if you do not have faith in management’s projections?
Ask!
If you cannot ask, increase the discount rate or come up with your own.
You can also pass on the opportunity
How could a company have a negative equity value?
If we’re talking market cap, it’s impossible.
Equity holders are never “on the hook” unless it’s tort, negligence, fraud, etc. But their downside is zero
Should the cost of equity be higher for a $5 billion company or a $500 million company? What about WACC?
All else equal, $500mm company.
- Lower economies of scale and general operating leverage
- Brand name and recognition may come into a play
However, depends on their debt and their rates of debt
WACC - again it depends. I would say that the larger company would have a lower cost of debt capital as well. (more assets, easier to syndicate)
How do you know if your DCF is too dependent on future assumptions?
Terminal value as a % of EV
When might you see negative TEV?
Net cash position with little equity value (financial institution)
Assume that a company has 100 shares outstanding at $10 each. It also has 10 options outstanding with an exercise price of $5. What is the fully diluted equity value?
10 - 5*10/10=5
105*10=$1,050
You have two companies and each has a constant EBITDA of $50 in the foreseeable future. One is a manufacturing company and the other is a consulting firm. Which company do you think is more valuable?
Consulting firm
- Manufacturing firm will have higher Capex which will reduce FCF
- Manufacturing firm likely has more debt on its balance sheet
- Consulting firm’s assets are its people. People can take a hair cut in costs and still run while machines still need to be repaired
- Consultants are paid by the hour so you can cut costs
You have two companies. Company A has EBITDA growing at 10% and Company B has EBITDA growing at 20%. Both companies are in the same industry and have the same capital structure. The industry average EBITDA growth rate is 15%. Which company would you invest in? Why? What are some disadvantages to the option you chose
At first impression, I’d invest in Company A. Growing at a rate above the industry with what seems to be a fair capital structure. However, I can poke holes
- Size of EBITDA ($)
- One time EBITDA gain? One more mature than another
- Intangibles - strength of customers, suppliers, brand
- One company vertically integrated and one if its product segments has been underperforming
You are acquiring a company and are allowed to ask the CEO one question in order to determine how much you will pay. What would you ask? If you could ask one follow-up question, what would it be?
How much equity would you own in this company?
Why would you not want the equity?
He she knows more about the company than me.
Other questions
- What keeps you up at night
Guide says “FCF and Growth of FCF”
What are the differences between a WACC and an asset beta?
Asset Beta is unlevered.
WACC is a different concept
What are the drawbacks of using WACC in valuing companies?**
Capital structure is static
No change in Risk of New Projects
- New projects have the same risk of existing
What would greater impact a firms valuation, a 10% reduction in revenues or 1% reduction in discount rate?
Depends on cash flows and the size / timing. Size of revenue and initial discount rate
I would say a 1% reduction in discount rate
What is the average P/E ratio within the S&P 500? Is Google’s P/E higher of lower? What is it? Is GE’s P/E higher or lower? What is it? Why is that?
15?
Higher
Lower - used to be a diversified conglomerate when companies were rewarded for their diversification. Now not as much
What industry do you follow and what numbers do you look at to determine if a firm is doing well in the industry?
Consumer
- SSS
- Holiday performance
- Free cash flow
- Cash conversion cycle and working capital
If a company has $30mm EBITDA, $20mm FCF, $100mm in debt and can sell itself for $300mm TEV, what is the break-even multiple after 2 years assuming no EBITDA growth?
No answer in guide
$200mm equity value (300-100) Net debt reduction to 40 (100-2*20) 1x multiple $200 equity + 40 240/30 8x (Purchased at 10x)
How do you begin with analyzing a new company?
Industry and competitive positioning
- First thing, barriers to entry: market share over time
- Size of the industry and how fast it’s growing
- Consolidating, fragmented, technology, regulation, M&A?
- Competitive structure: Porter’s 5 forces
Company
- What does it do; product mix
- Market share here. Competitive positioning. Why do consumers buy their products over a competitor? (Brand, quality, price?)
- Growth - Organic / inorganic**
- Customers - elasticity? Switching costs?
- Substitutes
- suppliers
- Value chain and distro channels
Financials: do they back up the story?
- FCF generation?
- Sales: recurring? Organic?
- Expenses: operating leverage?
- Capitalization?
- FCF and working capital
- Credit support
Operations
- Levers. Regulatory risks. Customer concentration. Cyclicality. Drivers of performance
Management and business plan
- How experienced is management? How is their capital allocation?
- Business plan realistic?
Considerations and Risk
Is it a good LBO candidate?
Exit?
How do you view maintenance, growth and acquisition capital expenditures when analyzing a company? How do you forecast stability of cash flows? How do you describe cyclicality and seasonality? Are they good or bad?
Maintenance are needed as long as the company can afford
- Growth - worth it if the increase in profits (ROI) make it worth it. I would benchmark against other capital allocation measures, such as buybacks, M&A, marketing etc
Stability of cash flows = recurring revenue? Variable costs? Capex needed? Working capital swings?
Cyclicality = business performance subject to businss
Walk me through pre and post deal equity valuation.
Is the deal accretive?
What analysis would you perform if you were presented with a management team’s financial plan?
Do I trust it?
- Channel checks
What are the features of a good business model?
Stable, defensible cash flows Experienced management Industry tailwinds Strong competitive positioning Realistic projections Operational levers Sponsor add value Divestable assets Good exit
