Valuation Flashcards
What’s the point of valuation? WHY do you value a company?
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.
Public companies already have Market Caps and Share Prices. Why bother valuing them?
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! You value companies to see if the market’s views are correct or incorrect.
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, for example, volatile companies, where it may undervalue companies’ long-term potential.
Precedent Transactions are useful because they’re based on the real prices companies have paid for other companies, and they may reflect industry trends better than Public Comps. However, the data is often misleading. There may not be truly comparable transactions. Specific deal terms and market conditions might also distort the multiples.
Discounted cash flow Analysis is almost always used in valuations. 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. Disagreements do arise as well over the proper calculations for key figures like the Cost of Equity and WACC. So when it is difficult to estimate discount rates, the other methodologies can be more useful.
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. “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 (the extra amount that acquirers must pay to acquire sellers.”
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 asset-intensive 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 appropriately.
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?
The most common signs of trouble are:
1. 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.
2. 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.
3. 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.
4. 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.
