Valuation - Basic

Question 1

What do you actually use a valuation for?

Answer 1

Usually you use it in pitch books and in client presentations when you’re providing updates and telling them what they should expect for their own valuation. It’s also used right before a deal closes in a Fairness Opinion, a document a bank creates that “proves” the value their client is paying or receiving is “fair” from a financial point of view. Valuations can also be used in defense analyses, merger models, LBO models, DCFs (because terminal multiples are based off of comps), and pretty much anything else in finance.

Question 2

What are the most common multiples used in Valuation?

Answer 2

The most common multiples are EV/Revenue, EV/EBITDA, EV/EBIT, P/E (Share Price / Earnings per Share), and P/BV (Share Price / Book Value per Share).

Question 3

Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?

Answer 3

Warren Buffett once famously said, “Does management think the tooth fairy pays for capital expenditures?” He dislikes EBITDA because it hides the Capital Expenditures companies make and disguises how much cash they are actually using to finance their operations.

In some industries there is also a large gap between EBIT and EBITDA – anything that is very capital-intensive, for example, will show a big disparity. Note that EBIT itself does not include Capital Expenditures, but it does include Depreciation and that is directly linked to CapEx – that’s the link. If a company has a high Depreciation expense, chances are it has a high CapEx.

Question 4

Let’s say we’re valuing a private company. Why might we discount the public company comparable multiples but not the precedent transaction multiples?

Answer 4

There’s no discount because with precedent transactions, you’re acquiring the entire company – and once it’s acquired, the shares immediately become illiquid.

But shares – the ability to buy individual “pieces” of a company rather than the whole thing – can be either liquid (if it’s public) or illiquid (if it’s private). Since shares of public companies are always more liquid, you would discount public company comparable multiples to account for this.

Question 5

Can you use private companies as part of your valuation?

Answer 5

Only in the context of precedent transactions – it would make no sense to include them for public company comparables or as part of the Cost of Equity / WACC calculation in a DCF because they are not public and therefore have no values for market cap or Beta.

Question 6

How do you select Comparable Companies / Precedent Transactions?

Answer 6

The 3 main ways to select companies and transactions:

1. Industry classification
2. Financial criteria (Revenue, EBITDA, etc.)
3. Geography

For Precedent Transactions, you often limit the set based on date and only look at transactions within the past 1-2 years. The most important factor is industry – that is always used to screen for companies/transactions, and the rest may or may not be used depending on how specific you want to be.

Here are a few examples:

Comparable Company Screen: Oil & gas producers with market caps over $5 billion

Comparable Company Screen: Digital media companies with over $100 million in revenue

Precedent Transaction Screen: Airline M&A transactions over the past 2 years involving sellers with over $1 billion in revenue

Precedent Transaction Screen: Retail M&A transactions over the past year

Question 7

What other Valuation methodologies are there?

Answer 7

Other methodologies include:

1. Liquidation Valuation – Valuing a company’s assets, assuming they are sold off and then subtracting liabilities to determine how much capital, if any, equity investors receive
2. Replacement Value – Valuing a company based on the cost of replacing its assets
3. LBO Analysis – Determining how much a PE firm could pay for a company to hit a “target” IRR, usually in the 20-25% range
4. Sum of the Parts – Valuing each division of a company separately and adding them together at the end
5. M&A Premiums Analysis – Analyzing M&A deals and figuring out the premium that each buyer paid, and using this to establish what your company is worth
6. Future Share Price Analysis – Projecting a company’s share price based on the P / E multiples of the public company comparables, then discounting it back to its present value

Question 8

How would you present these Valuation methodologies to a company or its investors?

Answer 8

Usually you use a “football field” chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number. As an example, see page 10 of this document (a Valuation done by Credit Suisse for the Leveraged Buyout of Sungard Data Systems in 2005): http://edgar.sec.gov/Archives/edgar/data/789388/000119312505074184/dex99c2.htm

Question 9

When would you use a Liquidation Valuation?

Answer 9

This is most common in bankruptcy scenarios and is used to see whether equity shareholders will receive any capital after the company’s debts have been paid off. It is often used to advise struggling businesses on whether it’s better to sell off assets separately or to try and sell the entire company.

Question 10

You mentioned that Precedent Transactions usually produce a higher value than Comparable Companies – can you think of a situation where this is not the case?

Answer 10

Sometimes this happens when there is a substantial mismatch between the M&A market and the public market.

For example, no public companies have been acquired recently but there have been a lot of small private companies acquired at extremely low valuations. For the most part this generalization is true but there are exceptions to almost every “rule” in finance.

Question 11

Rank the 3 valuation methodologies from highest to lowest expected value.

Answer 11

Trick question – there is no ranking that always holds. In general, Precedent Transactions will be higher than Comparable Companies due to the Control Premium built into acquisitions. Beyond that, a DCF could go either way and it’s best to say that it’s more variable than other methodologies. Often it produces the highest value, but it can produce the lowest value as well depending on your assumptions.

Question 12

The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company’s profitability. What’s the difference between them, and when do you use each one?

Answer 12

P / E depends on the company’s capital structure whereas EV / EBIT and EV / EBITDA are capital structure-neutral. Therefore, you use P / E for banks, financial institutions, and other companies where interest payments / expenses are critical.

EV / EBIT includes Depreciation & Amortization whereas EV / EBITDA excludes it – you’re more likely to use EV / EBIT in industries where D&A is large and where capital expenditures and fixed assets are important (e.g. manufacturing), and EV / EBITDA in industries where fixed assets are less important and where D&A is comparatively smaller (e.g. Internet companies).

Question 13

You never use Equity Value / EBITDA, but are there any cases where you might use Equity Value / Revenue?

Answer 13

It’s very rare to see this, but sometimes large financial institutions with big cash balances have negative Enterprise Values – so you might use Equity Value / Revenue instead. You might see Equity Value / Revenue if you’ve listed a set of financial institutions and non-financial institutions on a slide, you’re showing Revenue multiples for the nonfinancial institutions, and you want to show something similar for the financial institutions. Note, however, that in most cases you would be using other multiples such as P/E and P/BV with banks anyway.

Question 14

When do you use an LBO Analysis as part of your Valuation?

Answer 14

Obviously you use this whenever you’re looking at a Leveraged Buyout – but it is also used to establish how much a private equity firm could pay, which is usually lower than what companies will pay. It is often used to set a “floor” on a possible Valuation for the company you’re looking at.

Question 15

When would you use Sum of the Parts?

Answer 15

This is most often used when a company has completely different, unrelated divisions – a conglomerate like General Electric, for example. If you have a plastics division, a TV and entertainment division, an energy division, a consumer financing division and a technology division, you should not use the same set of Comparable Companies and Precedent Transactions for the entire company. Instead, you should use different sets for each division, value each one separately, and then add them together to get the Combined Value.

Question 16

Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium?

Answer 16

This could happen for a number of reasons: • The company has just reported earnings well-above expectations and its stock price has risen recently. • It has some type of competitive advantage not reflected in its financials, such as a key patent or other intellectual property. • It has just won a favorable ruling in a major lawsuit. • It is the market leader in an industry and has greater market share than its competitors.

Question 17

Would an LBO or DCF give a higher valuation?

Answer 17

Technically it could go either way, but in most cases the LBO will give you a lower valuation. Here’s the easiest way to think about it: with an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year – you’re only valuing it based on its terminal value. With a DCF, by contrast, you’re taking into account both the company’s cash flows in between and its terminal value, so values tend to be higher. Note: Unlike a DCF, an LBO model by itself does not give a specific valuation. Instead, you set a desired IRR and determine how much you could pay for the company (the valuation) based on that.

Question 18

What are the 3 major valuation methodologies?

Answer 18

Comparable Companies, Precedent Transactions and Discounted Cash Flow Analysis.

Question 19

How do you value a private company?

Answer 19

You use the same methodologies as with public companies: public company comparables, precedent transactions, and DCF. But there are some differences:

1. • You might apply a 10-15% (or more) discount to the public company comparable multiples because the private company you’re valuing is not as “liquid” as the public comps.
2. • You can’t use a premiums analysis or future share price analysis because a private company doesn’t have a share price.
3. • Your valuation shows the Enterprise Value for the company as opposed to the implied per-share price as with public companies.
4. • A DCF gets tricky because a private company doesn’t have a market capitalization or Beta – you would probably just estimate WACC based on the public comps’ WACC rather than trying to calculate it.

Question 20

When you’re looking at an industry-specific multiple like EV / Scientists or EV / Subscribers, why do you use Enterprise Value rather than Equity Value?

Answer 20

You use Enterprise Value because those scientists or subscribers are “available” to all the investors (both debt and equity) in a company. The same logic doesn’t apply to everything, though – you need to think through the multiple and see which investors the particular metric is “available” to.

Question 21

When would a Liquidation Valuation produce the highest value?

Answer 21

This is highly unusual, but it could happen if a company had substantial hard assets but the market was severely undervaluing it for a specific reason (such as an earnings miss or cyclicality). As a result, the company’s Comparable Companies and Precedent Transactions would likely produce lower values as well – and if its assets were valued highly enough, Liquidation Valuation might give a higher value than other methodologies.

Question 22

What are some examples of industry-specific multiples?

Answer 22

Technology (Internet): EV / Unique Visitors, EV / Pageviews Retail / Airlines: EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rental Expense) Energy: EV / EBITDAX (Earnings Before Interest, Taxes, Depreciation, Amortization & Exploration Expense), EV / Daily Production, EV / Proved Reserve Quantities Real Estate Investment Trusts (REITs): Price / FFO per Share, Price / AFFO per Share (Funds From Operations, Adjusted Funds From Operations) Technology and Energy should be straightforward – you’re looking at traffic and energy reserves as value drivers rather than revenue or profit. For Retail / Airlines, you add back Rent because some companies own their own buildings and capitalize the expense whereas others rent and therefore have a rental expense. For Energy, all value is derived from companies’ reserves of oil & gas, which explains the last 2 multiples; EBITDAX exists because some companies capitalize (a portion of) their exploration expenses and some expense them. You add back the exploration expense to normalize the numbers. For REITs, Funds From Operations is a common metric that adds back Depreciation and subtracts gains on the sale of property. Depreciation is a non-cash yet extremely large expense in real estate, and gains on sales of properties are assumed to be non-recurring, so FFO is viewed as a “normalized” picture of the cash flow the REIT is generating.

Question 23

What are some flaws with precedent transactions?

Answer 23

• Past transactions are rarely 100% comparable – the transaction structure, size of the company, and market sentiment all have huge effects.
• Data on precedent transactions is generally more difficult to find than it is for public company comparables, especially for acquisitions of small private companies.

Question 24

Do you ALWAYS use the median multiple of a set of public company comparables or precedent transactions?

Answer 24

There’s no “rule” that you have to do this, but in most cases you do because you want to use values from the middle range of the set.

But if the company you’re valuing is distressed, is not performing well, or is at a competitive disadvantage, you might use the 25th percentile or something in the lower range instead – and vice versa if it’s doing well.

Question 25

How would you value an apple tree?

Answer 25

The same way you would value a company: by looking at what comparable apple trees are worth (relative valuation) and the value of the apple tree’s cash flows (intrinsic valuation). Yes, you could do a DCF for anything – even an apple tree.

Question 26

Let’s go back to 2004 and look at Facebook back when it had no profit and no revenue. How would you value it?

Answer 26

You would use Comparable Companies and Precedent Transactions and look at more “creative” multiples such as EV/Unique Visitors and EV/Pageviews rather than EV/Revenue or EV/EBITDA. You would not use a “far in the future DCF” because you can’t reasonably predict cash flows for a company that is not even making money yet. This is a very common wrong answer given by interviewees. When you can’t predict cash flow, use other metrics – don’t try to predict cash flow anyway!

Question 27

What would you use in conjunction with Free Cash Flow multiples – Equity Value or Enterprise Value?

Answer 27

Trick question. For Unlevered Free Cash Flow, you would use Enterprise Value, but for Levered Free Cash Flow you would use Equity Value. Remember, Unlevered Free Cash Flow excludes Interest and thus represents money available to all investors, whereas Levered FCF already includes the effects of the Interest expense (and mandatory debt repayments) and the money is therefore only available to equity investors. Debt investors have already “been paid” with the interest payments and principal re payments they received.

Question 28

Two companies have the exact same financial profiles and are bought by the same acquirer, but the EBITDA multiple for one transaction is twice the multiple of the other transaction – how could this happen?

Answer 28

Possible reasons:

1. One process was more competitive and had a lot more companies bidding on the target.
2. One company had recent bad news or a depressed stock price so it was acquired at a discount.
3. They were in industries with different median multiples.

Question 29

What are the flaws with public company comparables?

Answer 29

• No company is 100% comparable to another company.
• The stock market is “emotional” – your multiples might be dramatically higher or lower on certain dates depending on the market’s movements.
• Share prices for small companies with thinly-traded stocks may not reflect their full value.

Question 30

If you were buying a vending machine business, would you pay a higher multiple for a business where you owned the machines and they depreciated normally, or one in which you leased the machines? The cost of depreciation and lease are the same dollar amounts and everything else is held constant.

Answer 30

You would pay more for the one where you lease the machines. Enterprise Value would be the same for both companies, but with the depreciated situation the charge is not reflected in EBITDA – so EBITDA is higher, and the EV / EBITDA multiple is lower as a result.

For the leased situation, the lease would show up in SG&A so it would be reflected in EBITDA, making EBITDA lower and the EV / EBITDA multiple higher.

Question 31

Why can’t you use Equity Value / EBITDA as a multiple rather than Enterprise Value / EBITDA?

Answer 31

EBITDA is available to all investors in the company – rather than just equity holders. Similarly, Enterprise Value is also available to all shareholders so it makes sense to pair them together. Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect the company’s entire capital structure – only the part available to equity investors.

Question 32

When would you not use a DCF in a Valuation?

Answer 32

You do not use a DCF if the company has unstable or unpredictable cash flows (tech or bio-tech startup) or when debt and working capital serve a fundamentally different role. For example, banks and financial institutions do not re-invest debt and working capital is a huge part of their Balance Sheets – so you wouldn’t use a DCF for such companies.

Question 33

How do you take into account a company’s competitive advantage in a valuation?

Answer 33

1. Look at the 75th percentile or higher for the multiples rather than the Medians.
2. Add in a premium to some of the multiples.
3. Use more aggressive projections for the company. In practice you rarely do all of the above – these are just possibilities.

Question 34

How do you apply the 3 valuation methodologies to actually get a value for the company you’re looking at?

Answer 34

Sometimes this simple fact gets lost in discussion of Valuation methodologies. You take the median multiple of a set of companies or transactions, and then multiply it by the relevant metric from the company you’re valuing.

Example: If the median EBITDA multiple from your set of Precedent Transactions is 8x and your company’s EBITDA is $500 million, the implied Enterprise Value would be $4 billion.

To get the “football field” valuation graph you often see, you look at the minimum, maximum, 25th percentile and 75th percentile in each set as well and create a range of values based on each methodology.