VALUATION Flashcards
Valuation: Core Purpose?
Calculate Co’s IMPLIED Value and compare it w/ Co’s CURRENT value
- current value = markets could be wrong. value co’s to see if market is wrong.
- make recommendations to buy or not to buy a co (undervalued vs. overvalued)
- sell-side: what you can expect to get if you sell
Why is valuation more complicated than the simple formula of Company Value = Cash Flow / (Discount Rate - CF Growth Rate)?
In reality, the Discount Rate & CF Growth rate change over time.
What are 2 ways to more accurately value a company? (As compared to simple Company Value formula)
1) DCF Analysis: Valuing a co based on its CFs (often called intrinsic valuation)
2) Relative Valuation: Use valuation multiples
Discounted Cash Flow Analysis - what is it?
Valuing a co based on its CFs; this method is often called intrinsic valuation.
1) PROJECT CO’S CASH FLOWS in detail in explicit forecast period (usually next 5-15 years) (future). –> Discount these CFs to their Present Value ==> Add them up.
2) Then, assume the Co’s CF Growth Rate & Discount Rate stay the same in the TERMINAL PERIOD –> Find Terminal Value: value the CO in THAT TERMINAL PERIOD using the Company Value Formula = Cash Flow / (Discount Rate - CF Growth Rate) ==> Discount Co’s Terminal Value to its PV
3) Add PV of Terminal Value to Discounted CFs from first 5-15 years ==> = Implied Value of Co
What is the most THEORETICALLY correct way to value a co?
DCF - b/c valuing co based on its CFs, rather than external factors like other companies ==> often called “intrinsic valuation”
Relative Valuation - what is it?
Use VALUATION MULTIPLES for the company’s near-term financial results (ex: next 1-2 years) & don’t rely on long-term CF projections.
–> Valuation Multiples = shorthand for CF-based valuation
To use: 1) collect set of “comparable” companies and M&A transactions –> 2) calculate their valuation multiples –> 3) apply multiples to the co you are valuing
What type of CF to use in DCF?
Usually should use UNLEVERED FCF
- if you use unlevered -> DCF produces EV
- if you use levered -> DCF produce EqV, rather than EV
Unlevered Free Cash Flow (UFCF) - What is it/what does it represent? Advantages over other types of FCF?
UFCF = represents discretionary CF avail from core business to ALL investors.
2 main advantages over other types of FCF:
1) CONSISTENCY: UFCF does not depend on co’s capital structure => will get same results even if co issues Debt, Equity, repays Debt, etc.
2) EASE OF PROJECTING: Ignore Net Income Expense in the analysis ==> so, don’t need to project items like Debt, Cash, interest rates on Debt & Cash –> less research, faster conclusion
Unlevered FCF - What items should it consist of? What items to ignore & why?
UFCF = represents discretionary CF avail from core business to ALL investors.
Consists of:
1. (ADD) Revenue
2. (DEDUCT) COGS & Operating Expenses (deduct full Lease Expense as well!)
3. (DEDUCT) Taxes
4. (ADD) Depreciation & amoritization (and sometimes other non-cash add-backs)
5. (ADD OR DEDUCT) Change in Working Capital
6. (DEDUCT) Capital Expenditures
IGNORE: 1) Non-recurring items or 2) items that relate only to specific investor groups, rather than ALL investors.
(–> So, ignore: Net Interest Expense, Other Income / (Expense), MOST of the non-cash adjustments, CF from Financing section, most of CF from Investing section)
What “Non-Cash Adjustments” on CFS are included vs. excluded from Unlevered FCF?
- D&A is included. Sometimes Deferred Income Taxes are included, but not much else.
- MOST of non-cash adjustments are excluded b/c:
1) Most of them are non-recurring (ex: Gains & Losses, Impairments, Write-Downs). ==> So, when you PROJECT FCF: ignore non-recurring items in the future; or
2) Stock-based compensation (common, recurring item in non-cash adj section) = NOT a real non-cash expense & relates only to a specific investor group (common SHs)
Stock-based compensation (SBC) - is it a true non-cash expense?
No b/c it creates additional shares –> dilutes existing investors. ==> So, still costs you money)
==> So, can’t add SBC back to Unlevered FCF as non-cash expense. (Otherwise, not reflecting existing SHs’ reduced ownership in the Co)
Interest Expense and Other Expense / (Income) - why is it ignored in UFCF formula?
They’re only available to certain investor groups
Discount Rate - definition; implications of higher/lower Discount Rate
Discount Rate = Opportunity cost for investor: what they could earn by investing in other, similar companies
Higher Discount Rate = implies higher risk/potential returns; makes co LESS valuable - b/c means investor has better options elsewhere
Lower Discount Rate = implies lower risk/potential returns; makes co MORE valuable - b/c means investor has worse options elsewhere
Why do companies have multiple Discount Rates?
What are most impt Discount Rates for valuation/DCF purposes?
- Since co’s have multiple sources of capital (can invest in a co in diff ways: buy its shares, bonds, Preferred Stock, other securities) –> multiple Discount Rates ==> each part of capital structure has diff rate
- Most important Rates:
1) Cost of Equity: “opportunity cost” for common stock - what investors can earn from a) stock price increases & b) dividends
2) Cost of Debt: for co’s outstanding debt - represents “yield” investors can earn from a) interest payments and b) diff bt market value of debt & amount co will repay upon maturity
3) Preferred Stock: for Preferred Stock - similar to Cost of Debt (but Preferred Stock tends to have higher coupon rates & Preferred Dividends also are not tax-deductible)
Weighted Average Cost of Capital (WACC) - definition/intuition; formula; why does it always pair w/ unlevered FCF?
WACC = Cost of Equity * % of Equity + Cost of Debt * % of Debt * (1 - Tax Rate) + Cost of Preferred Stock * % of Preferred Stock
WACC = represents OVERALL Discount Rate for entire company
-If you invest proportionally in co’s entire capital structure –> WACC = expected, long-term annualized return
- to a co: WACC = cost of funding its operations by using ALL its sources of capital & keeping its cap structure %s the same over time
–> always pairs w/ UFCF b/c both represent ALL investors in the co
- investors: might invest in a co if its expected IRR exceeds WACC, and a co might decide to fund a new project, acq, or expansion if its expected IRR exceeds WACC
Cost of Debt & Cost of Preferred Stock: What do these rates represent? How to approximate?
Represents rates would pay if it issued ADDITIONAL Debt or Preferred Stock.
*can estimate:
- calculate weighted avg coupon rate on existing debt/pref stock
- median coupon rate on oustanding issuances of comparable public companies
==> Can’t predict, but can approximate: look at co’s current Debt & Preferred Stock
1) Coupon rate(s) –> approximate for Pre-Tax Cost of Debt
2) YTM
3) Risk-free Rate + “default spread” based on co’s expected credit rating after it issues additional debt
**
- look at comparable co’s / debt issues & int rates & yields issued by similar co’s to get estimates
Cost of Debt & Cost of Preferred Stock: Market Value vs. Face Value
Cost of Equity - definition; how to estimate - GENERAL
Represents how much a co’s stock “should” return each year, on avg, over long-term, factoring in both 1) stock-price appreciation and 2) dividends
- co “pays” for equity in 2 ways:
1) gives up stock appreciation rights to other investors (losing some of upside - non-cash expense)
2) issuing dividends (cash expense)
To estimate: usually use Capital Asset Pricing Model (CAPM) –
Cost of Equity = Risk Free Rate + Equity Risk Premium * Levered Beta
–> estimates co’s expected return b/c difficult in practice to est impact of both of these
Risk-Free Rate - definition; how to calculate
- Represents what you can earn (interest rate) on “riskless security” (“safe” govt bonds)
- usually, look at yields of 10 year government bonds (or 20 year bonds) in country of same currency as co’s CFs
- IF govt bonds in the co are NOT risk-free (ex: Greece): take Rf Rate from country that is (Ex: US, UK) & add a default spread based on co’s credit rating
–> intuition: add the default spread to show risk that this govt has a higher change of defaulting
Levered Beta - definition; how to calculate
Represents VOLATILITY of this stock relative to the market as a whole; reflects risk of both 1) co’s intrinsic business risk and 2) risk introduced by leverage (Debt)
Ex: If Beta = 1 –> when market goes up 10%, co’s stock goes up 10%.
Ex: If Beta = 0.5 –> when market goes up 10%, co’s stock goes up 5%
To calculate:
1) Easy Method = HISTORICAL Beta: based on co’s price history (stock performance vs. relevant index); or
2) Harder Method = Analyze comparable companies
- WHY?: 1) get proper range of values for COE => leads to range for WACC too and 2) point of valuation is to determine Co’s IMPLIED Value (contra: co’s past performance = more in line w/ Current Value)
*When you look up a co, it is already LEVERED: co’s previous stock price movements already priced in (reflects) the co’s debt they’ve taken on
Equity Risk Premium - how to calculate for multinational co in many geographies?
Equity Risk Premium - definition; how to calculate
- Represents percentage the stock market will return each year, on avg, above yield on “safe” govt bonds
–> EXTRA yield you can early by investing in an index that tracks stock market
–
To calculate: ALWAYS linked to company’s country & domestic stock market.
BUT 3 points of disagreement on how to calculate –
1) Historical vs. Projected numbers? – Projected ones make more sense, but how to “project” stock market?
2) Arithmetic vs. geometric mean?
3) Period?
==> Pick reasonable range of values (look at a few data sources), rather than argue for single #
–
- can take historical data from US stock market + add a premium based on default spread in a specific co
- some groups also use a standard # for each market (ex: 5-6% in developed countries)
Beta - intuition
- beta measures a co’s “risk” (compared to rest of the market
- Beta represent 2 types of risk:
1) inherent BUSINESS risk
2) risk from DEBT (leverage)
(ex: defaulting on debt; not being able to pay interest)
Beta - intuition behind using using comparable companies beta vs. historical beta?
- assumption that co’s “true” riskiness = more in-line w/ how risky similar co’s in the market are, than to its own historical track record
–> figuring out what a co’s beta SHOULD be, rather than what it currently is - in a valuation, trying to est a co’s implied value - what it should be worth.
- using historical beta corresponds more closely w/ co’s CURRENT value