Valuation Flashcards
What is equity value and how is it calculated?
The present value concept is based on the premise that “a dollar in the present is
worth more than a dollar in the future” due to the time value of money. The reason
being money currently in possession has the potential to earn interest by being
invested today.
Present value = Cash flow / (1+r)
For intrinsic valuation methods, the value of a company will be equal to the sum of the
present value of all the future cash flows it generates. Therefore, a company with a high
valuation would imply it receives high returns on its invested capital by investing in positive net present value
(“NPV”) projects consistently while having low risk associated with its cash flows.
Could you explain the concept of present value and how it relates to company valuations?
The present value concept is based on the premise that “a dollar in the present is
worth more than a dollar in the future” due to the time value of money. The reason
being money currently in possession has the potential to earn interest by being
invested today.
Present Value = Cash Flow / (1+r)^t
For intrinsic valuation methods, the value of a company will be equal to the sum of the
present value of all the future cash flows it generates. Therefore, a company with a high
valuation would imply it receives high returns on its invested capital by investing in positive net present value
(“NPV”) projects consistently while having low risk associated with its cash flows.
How do you calculate the fully diluted number of shares outstanding?
The treasury stock method (“TSM”) is used to calculate the fully diluted number of
shares outstanding based on the options, warrants, and other dilutive securities that
are currently “in-the-money” (i.e., profitable to exercise).
The TSM involves summing up the number of in-the-money (“ITM”) options and
warrants and then adding that figure to the number of basic shares outstanding.
In the proceeding step, the TSM assumes the proceeds from exercising those dilutive
options will go towards repurchasing stock at the current share price to reduce the net
dilutive impact.
What is enterprise value and how do you calculate it?
Conceptually, enterprise value (“EV”) represents the value of the operations of a
company to all stakeholders including common shareholders, preferred shareholders,
and debt lenders.
Thus, enterprise value is considered capital structure neutral, unlike equity value,
which is affected by financing decisions.
Enterprise value is calculated by taking the company’s equity value and adding net
debt, preferred stock, and minority interest.
Enterprise Value = Equity Value + Net Debt + Preferred Stock + Minority Interest
How do you calculate equity value from enterprise value?
To get to equity value from enterprise value, you would first subtract net debt, where net debt equals the
company’s gross debt and debt-like claims (e.g., preferred stock), net of cash, and non-operating assets.
Equity Value = Enterprise Value – Net Debt – Preferred Stock – Minority Interest
Which line items are included in the calculation of net debt?
The calculation of net debt accounts for all interest-bearing debt, such as short-term
and long-term loans and bonds, as well as non-equity financial claims such as
preferred stock and non-controlling interests. From this gross debt amount, cash and
other non-operating assets such as short-term investments and equity investments are
subtracted to arrive at net debt.
Net Debt = Total Debt – Cash & Equivalents
When calculating enterprise value, why do we add net debt (as opposed to total debt)?
The underlying idea of net debt is that the cash on a company’s balance sheet could pay down the outstanding
debt if needed. For this reason, cash and cash equivalents are netted against the company’s debt, and many
leverage ratios use net debt rather than the gross amount.
What is the difference between enterprise value and equity value?
Enterprise value represents all stakeholders in a business, including equity
shareholders, debt lenders, and preferred stock owners. Therefore, it’s independent of
the capital structure. In addition, enterprise value is closer to the actual value of the
business since it accounts for all ownership stakes (as opposed to just equity owners).
To tie this to a recent example, many investors were astonished that Zoom, a video
conferencing platform, had a higher market capitalization than seven of the largest
airlines combined at one point. The points being neglected were:
- The equity values of the airline companies were temporarily deflated given the travel restrictions, and the
government bailout had not yet been announced. - The airlines are significantly more mature and have far more debt on their balance sheet (i.e., more non-
equity stakeholders).
Could a company have a negative net debt balance and have an enterprise value lower than its
equity value?
Yes, negative net debt just means that a company has more cash than debt. For example, both Apple and
Microsoft have massive negative net debt balances because they hoard cash. In these cases, companies will
have enterprise values lower than their equity value.
If it seems counter-intuitive that enterprise value can be lower than equity value, remember that enterprise
value represents the value of a company’s operations, which excludes any non-operating assets. When you
think about it this way, it should come as no surprise that companies with much cash (which is treated as a
non-operating asset) will have a higher equity value than enterprise value.
Can the enterprise value of a company turn negative?
While negative enterprise values are a rare occurrence, it does happen from time to time . A negative enterprise
value means a company has a net cash balance (total cash less total debt) that exceeds its equity value. Imagine
a company with $1,000 in cash, no other assets and $500 in debt and $200 in accounts payable. There is $300
in equity in this business, while the enterprise value is -$200.
If a company raises $250 million in additional debt, how would its enterprise value change?
Theoretically, there should be no impact as enterprise value is capital structure neutral. The new debt raised
shouldn’t impact the enterprise value, as the cash and debt balance would increase and offset the other entry.
However, the cost of financing (i.e., through financing fees and interest expense) could negatively impact the
company’s profitability and lead to a lower valuation from the higher cost of debt.
Why do we add minority interest to equity value in the calculation of enterprise value?
Minority interest represents the portion of a subsidiary in which the parent company doesn’t own. Under US
GAAP, if a company has ownership over 50% of another company but below 100% (called a “minority interest”
or “non-controlling investment”), it must include 100% of the subsidiary’s financials in their financial
statements despite not owning 100%.
When calculating multiples using EV, the numerator will be the consolidated metric, thus minority interest
must be added to enterprise value for the multiple to be compatible (i.e., no mismatch between the numerator
and denominator).
How are convertible bonds and preferred equity with a convertible feature accounted for when
calculating enterprise value?
If the convertible bonds and the preferred equities are “in-the-money” as of the valuation date (i.e., the current
stock price is greater than their strike price), then the treatment will be the same as additional dilution from
equity. However, if they’re “out-of-the-money,” they would be treated as a financial liability (similar to debt).
What are the two main approaches to valuation?
- Intrinsic Valuation: For an intrinsic valuation, the value of a business is arrived at
by looking at the business’s ability to generate cash flows. The discounted cash
flow method is the most common type of intrinsic valuation and is based on the
notion that a business’s value equals the present value of its future free cash flows. - Relative Valuation: In relative valuation, a business’s value is arrived at by
looking at comparable companies and applying the average or median multiples
derived from the peer group – often EV/EBITDA, P/E, or some other relevant
multiple to value the target. This valuation can be done by looking at the multiples of comparable public
companies using their current market values, which is called “trading comps,” or by looking at the
multiples of comparable companies recently acquired, which is called “transaction comps.”
What are the most common valuation methods used in finance?
Comparable Company Analysis
(“Trading Comps”)
Trading comps value a company based on how similar publicly-traded
companies are currently being valued at by the market.
Comparable Transactions Analysis
(“Transaction Comps”)
Transaction comps value a company based on the amount buyers paid to
acquire similar companies in recent years.
Discounted Cash Flow Analysis
(“DCF”)
DCFs value a company based on the premise that its value is a function of
its projected cash flows, discounted at an appropriate rate that reflects
the risk of those cash flows.
Leveraged Buyout Analysis
(“LBO”)
An LBO will look at a potential acquisition target under a highly
leveraged scenario to determine the maximum purchase price the firm
would be willing to pay.
Liquidation Analysis Liquidation analysis is used for companies under (or near) distress and
values the assets of the company under a hypothetical, worst-case
scenario liquidation.
Among the DCF, comparable companies analysis, and transaction comps, which approach yields
the highest valuation?
Transaction comps analysis often yields the highest valuation because it looks at valuations for companies that
have been acquired, which factor in control premiums. Control premiums can often be quite significant and as
high as 25% to 50% above market prices. Thus, the multiples derived from this analysis and the resulting
valuation are usually higher than a straight trading comps valuation or a standalone DCF valuation.
Which of the valuation methodologies is the most variable in terms of output?
Because of its reliance on forward-looking projections and discretionary assumptions, the DCF is the most
variable out of the different valuation methodologies. Relative valuation methodologies such as trading and
transaction comps are based on the actual prices paid for similar companies. While there’ll be some discretion
involved, the valuations derived from comps deviate to a lesser extent than DCF models.
Contrast the discounted cash flow (DCF) approach to the trading comps approach.
See page 48 for the accompanying table.
How can you determine which valuation method to use?
Each valuation method has its shortcomings; therefore, a combination of different valuation techniques should
be used to arrive at a range of valuation estimates. Using various methods allows you to arrive at a more
defensible approximation and sanity-check your assumptions.
The DCF and trading comps are often used in concert such that the comps provide a market-based sanity-check
to intrinsic DCF valuation (and vice versa).
For example, an analyst valuing an acquisition target may look at the past premiums and values paid on
comparable transactions to determine what the acquirer must realistically expect to pay. The analyst may also
value the company using a DCF to help show how far market prices are from intrinsic value estimates.
Another example of when the DCF and comps approaches can be used together is when an investor considers
investing in a business – the analyst may identify investing opportunities where comps-derived market values
for companies are significantly lower than valuations derived using a DCF (although it bears repeating that the
DCF’s sensitivity to assumptions is a frequent criticism).z
Would you agree with the statement that relative valuation relies less on the discretionary
assumptions of individuals?
That could be argued as an inaccurate statement. While a comps analysis often yields different valuations from
a DCF, that’s only because of inconsistent implicit assumptions across both approaches. If the implicit
assumptions of the comps analysis were entirely consistent with the explicit
assumptions of the DCF analysis, the valuations using both approaches would
theoretically be equal.
When you apply a peer-derived multiple to value a business, you’re still implicitly
making assumptions about future cash flows, cost of capital, and returns that you
would make explicitly when building a DCF. The difference is, you’re relying on the
assumptions used by others in the market.
So when you perform relative valuation, you assume the market consensus to be accurate or at least close to
the right value of a company and that those investors in the market are rational.
What does free cash flow (FCF) represent?
Free cash flow (“FCF”) represents a company’s discretionary cash flow, meaning the cash flow remaining after
accounting for the recurring expenditures to continue operating.
The simplest calculation of FCF is shown below:
Free Cash Flow (FCF) = Cash from Operations – Capex
The cash from investing section, other than capex, and the financing section are excluded because these
activities are optional and discretionary decisions up to management.
Why are periodic acquisitions excluded from the calculation of FCF?
The calculation of free cash flow should include only inflows/(outflows) of cash from the core, recurring
operations. That said, a periodic acquisition is a one-time, unforeseeable event, whereas capex is recurring and
a normal part of operations (i.e., capex is required for a business to continue operating).
Explain the importance of excluding non-operating income/(expenses) for valuations.
For both DCF analysis or comps analysis, the intent is to value the operations of the business, which requires
you to set apart the core operations to normalize the figures.
- When performing a DCF analysis, the cash flows projected should be strictly from the business’s recurring
operations, which would come from the sale of goods and services provided. A few examples of non-
operating income to exclude would be income from investments, dividends, or an asset sale. Each example
represents income that’s non-recurring and from a discretionary decision unrelated to the core operations. - When performing comps, the core operations of the target and its comparables are benchmarked. To make
the comparison as close to “apples to apples” as possible, non-core operating income/(expenses) and any
non-recurring items should be excluded.
Define free cash flow yield and compare it to dividend yield and P/E ratios.
The free cash flow yield (“FCFY”) is calculated as the FCF per share divided by the current share price. For this
calculation, FCF will be defined as cash from operations less capex.
Free Cash Flow Yield (FCFY) = Free Cash Flow Per Share / (Current Share Price)
Similar to the dividend yield, FCF yield can gauge equity returns relative to a company’s share price. Unlike
dividend yield, however, FCF yield is based on cash generated instead of cash actually distributed. FCF yield is
more useful as a fundamental value measure because many companies don’t issue dividends (or an arbitrary
fraction of their FCFs).
If you invert the FCF yield, you’ll get share price/FCF per share, which produces a cash flow version of the P/E
ratio. This has the advantage of benchmarking prices against actual cash flows as opposed to accrual profits.
However, it has the disadvantage that cash flows can be volatile, and period-specific swings in working capital
and deferred revenue can have a material impact on the multiple.