VALUATION COMPARABLE COMPANIES Flashcards
Provides an overview of comparable companies analysis, a method used to value a given focus company, division, business, or collection of assets. Provides a market benchmark against which a banker can establish a valuation for a private company or analyze the value of a public company at a given point in time. Used primarily for M&A, IPOs, Rx, and investment decisions.
1
Q
What is a comparable companies analysis?
A
Comparable companies analysis is one of the primary methodologies used for valuing a given focus company, division, business, or collection of assets (known as the target).
2
Q
What does a comparable companies analysis provide?
A
A comparable companies analysis provides a market benchmark against which a banker can establish valuation for a private company or analyse the value of a private company at a given point in time.
3
Q
In what applications do we use a comparable companies analysis?
A
There are a broad range of uses, such as for M&A situations, IPOs, Restructurings, and investment decision making.
4
Q
What is the premise of a comparable company analysis?
A
The foundation is built on the premise that similar companies provide a highly relevant reference point for valuing a target given the fact that they share key business and financial characteristics, performance drivers, and risks. Therefore, the banker can establish valuation parameters by determining the target’s relative position among its peers.
5
Q
What is the core of a comparable company analysis?
A
The core of the analysis involves selecting a universe of comparable companies for the target. The companies in the comparables universe are benchmarked against one another and the target based on various financial statistics and ratios. Trading multiples are calculated and used for extrapolating a valuation range for the target, which is calculated by applying the selected multiples to the target’s relevant financial statistics.
6
Q
What are some key valuation metrics used for trading multiples?
A
- Enterprise Value/EBITDA (EV/EBITDA)
2. Price/Earnings (P/E)
7
Q
Why are EV/EBITDA and P/E used? Following this, why those specific metrics?
A
For both ratios, the numerator consists of a measure of value for the company and the denominator is a financial statistic.
Multiples based on EV are used by bankers as they are independent of capital structure and other factors unrelated to business operations (tax regimes, accounting policies - GAAP / non GAAP)
8
Q
What type of valuation of the company does comparable company analysis provide?
A
The analysis reflects the “current” valuation based on prevailing market conditions and sentiment.
9
Q
Why may current valuation not be perfect at valuing the company?
A
Market trading levels may be subject to periods of irrational investor sentiment that could skew valuation either too high or too low. Further, no two companies are exactly the same so assigning a valuation based on the trading characteristics of similar companies may fail to capture the true value of the firm.
10
Q
What are the 5 steps to conducting a comparable companies analysis?
A
- Select the Universe of Comparable Companies
- Locate the Necessary Financial Information
- Spread Key Statistics, Ratios, and Trading Multiples
- Benchmark the Comparable Companies
- Determine Valuation
11
Q
On the base level, how do you determine a comparable company to add to the comparables universe?
A
Companies in the same sector (preferably sub-sector) with similar size tend to serve as good comparables.
12
Q
What do you use for a target with no clear public comparables?
A
Often you can try use companies outside the target’s core sector that share business and financial characteristics on some fundamental level.
For example, a medium-sized manufacturer of residential windows may have no true direct public comparable, however, if you were to expand this to include companies manufacturing building products, serve homebuilders, or exposure to the housing cycle, the size of the tangible universe increases.
13
Q
What information should you use to help study a comparable company?
A
For public registrants (Public companies or private companies who are subject to file with the SEC because of public debt securities), 10-K and 10-Q filings, consensus research estimates, equity and fixed income research reports, press releases, earnings call transcripts, investor presentations, and corporate websites provide key information
14
Q
What are the key business characteristics to profile a comparable company?
A
- Sector
- Products and Services
- Customers and End Markets
- Distribution Channels
- Geography
15
Q
What are the key financial characteristics to profile a comparable company?
A
- Size
- Profitability
- Growth Profile
- Return on Investment
- Credit Profile
16
Q
Describe why “sector” is an important business characteristic while profiling comparable companies?
A
A company’s sector conveys a great deal of information regarding key drivers, risks, and opportunities. For example, cyclical sectors such as oil & gas will have dramatically different earnings volatility than consumer staples. On the other hand, cyclical or highly fragmented sectors may present growth opportunities that are unavailable to companies in more stable or consolidated sectors.
17
Q
Describe why “product and services” is an important business characteristic while profiling comparable companies?
A
A company’s products and services are at the core of its business model. Accordingly, companies that produce similar products or provide similar services typically serve a reasonable comparables.
18
Q
Describe why “customers and end markets” is an important business characteristic while profiling comparable companies?
A
Customers: companies with a similar customer base tend to share similar opportunities and risks. For example, companies supplying automobile manufacturers abide by certain regulations (for distribution) and are subject to purchasing cycles and trends. The quantity and diversity of a company’s customers are also important. While it is generally positive to have low customer concentration from a risk management perspective, it is beneficial to have a stable customer core to provide visibility and comfort regarding revenue forecasting.
End Markets: end markets refer to broad underlying markets into which a company sells its products and services. A company’s performance is generally tied to economic and other factors that affect its end markets. Companies that sell products and services into the same end markets generally share similar performance outlook, which is important for determining appropriate comparable companies
19
Q
Describe why “distribution channels” is an important business characteristic while profiling comparable companies?
A
Distribution channels are a key driver of operating strategy, performance, and ultimately value. This is a result of organisation and cost structures dependent on specific levels and tiers of distribution channels.
20
Q
Describe why “geographies” is an important business characteristic while profiling comparable companies?
A
Companies that are based in (and sell to) different regions of the world often differ substantially in terms of fundamental business drivers and characteristics. These may include growth rates, macroeconomic factors, competitive dynamics, paths-to-market, organizational and cost structure, potential opportunities and potential risks. These differences can vary greatly from country to country and continent to continent. Consequently, there are often valuation disparities for similar companies in different global regions or jurisdictions. Therefore, a banker would tend to group U.S.-based (or focused) companies in a separate category from European- or Asian-based companies even if the basic business models are the same.
21
Q
Describe a time when geography as a business characteristic may be less applicable?
A
It is less applicable for truly global industries such as oil and aluminium where domicile is less indicative than global commodity prices and market conditions. However, this should be taken with a grain of salt as valuation disparities (as a result of geography) are often evident.
22
Q
Describe why “size” is an important financial characteristic while profiling comparable companies?
A
When we consider size, typically we measure in terms of market valuation (equity value and enterprise value) as well as key financial statistics (sales, gross profit, EBITDA, EBIT, and net income). Companies of similar size are more likely to have similar multiples than companies with significant size discrepancies. This reflects the fact that companies of similar size are also likely to be analogous in other respects, such as economies of scale, purchasing power, pricing leverage, customers, growth prospects, and trading liquidity of their shares in the stock market). Consequently, differences in size often map to differences in valuation.
23
Q
Describe why “profitability” is an important financial characteristic while profiling comparable companies?
A
A company’s profitability measures its ability to convert sales into profit. Profitability ratios employ a measure of profit in the numerator, such as gross profit, EBITDA, EBIT, or net income, and sales in the denominator. Companies in the same sector, higher profit margins translate to higher valuations all else being equal. Consequently, relative profitability is a core component of benchmarking analysis.
24
Q
Describe why “growth profile” is an important financial characteristic while profiling comparable companies?
A
A company’s growth profile, as determined by its historical and estimated future financial performances, is an important driver of valuation. Equity investors reward high growth companies with higher trading multiples than slower growing peers. They also discern whether growth is organic (preferable) or acquisition-driven. Historical and estimated future growth rates for financial statistics (such as EBITDA and EPS) are examined at selected intervals. For mature public companies, EPS are typically more meaningful. For early stage companies, with little or no earnings, sales or EBITDA growth trends may be more relevant.
25
Describe why "Return on Investment" is an important financial characteristic while profiling comparable companies?
Return on Investment (ROI) measures a company's ability to provide earnings (or returns) to its capital providers. ROI ratios employ a measure of profitability (EBIT, NOPAT, or net income) in the numerator and a measure of capital (Invested Capital, Shareholder's equity, total assets) in the denominator. Most commonly used ROI metrics are ROIC (invested capital), ROE (equity), ROA (assets). Dividend yield, which measures the dividend payment that a company's shareholders receive per share owned, is another return metric.
26
Describe why "credit profile" is an important financial characteristic while profiling comparable companies?
A company's credit profile refers to its creditworthiness as a borrower. It is typically measured by metrics relating to a company's overall debt level (leverage) as well as its ability to make interest payments (coverage), and reflects key company and sector-specific benefits and risks. Moody's, S&P, and Fitch ratings are the three primary independent credit rating agencies that provide formal assessments of a company's credit profile.
27
How do you screen for companies in a comparables company analysis?
Firstly, bankers check to see whether any established lists of comparable companies exist, as banks often update sector lists (with multiples and other financial data) each quarter.
Otherwise, the banker should examine the target's public competitors. These competitors generally share key business and financial characteristics and are susceptible to similar opportunities and risks. Public companies discuss their primary competitors in their 10-Ks, annual proxy statement DEF14A, and potentially in investor presentations.
Further, equity research reports, especially initiating coverage, often list research analyst views on target comparables and competitors.
An additional source for locating comparables is the proxy statement for a relatively recent M&A transaction in the merger proxy section as it contains excerpts from a fairness opinion.
Bankers could screen for companies in CapIQ, FactSet, and Thomson Reuters using SIC or NAICS codes. This is usually used to ensure no company is overlooked by casting a wide net.
Also, you could leverage the knowledge of the senior bankers on the team to determine comparable companies for the universe. Often senior bankers can refine a preened list to add nuanced opinion and expertise.
28
In trading comps, how is valuation driven? Which drivers are more meaningful?
Valuation is driven on the basis of both historical performance (LTM financial data) and expected future performance (consensus estimates for future calendar years). Depending on the sector and point in the cycle, financial projections tend to be more meaningful. Estimates for forward-year financial performance are typically sourced from consensus estimates.
In the context for M&A or debt capital raising transaction, more emphasis is placed on LTM financial performance, which is calculated on the basis of data obtained from a companies public filings
29
What is a 10-K report and what does it contain?
A 10-K is an annual report filed with the SEC by a public registrant that provides a comprehensive overview of the company and its prior year performance.
- detailed business description
- management discussion and analysis (MD&A)
- audited financial statements
- supplementary data
- outstanding debt detail
- basic shares outstanding
- stock options and warrant
- other information about the company sector, its segment details, customers, end markets, competitions, opportunities and risks, significant events, and acquisitions
30
What is a 10-Q report and what does it contain?
The 10-Q (quarterly) report is a quarterly report filed by a public registrant that provides an overview of the most recent quarter and year-to-date YTD period. It is less comprehensive than the 10-K, but provides financial statements, MD&A, and recent share count information and warrant/option information.
31
What is an 8-K report and what does it contain?
The 8-K (current) report is filed by a public registrant to report the occurrence of material corporate changes or events that are important to shareholders or security holders (typically within 4 days after occurrence). Key events include:
- earnings announcements
- entry into a definitive purchase/sale agreement
- completion of an acquisition or disposition of assets
- capital market transactions
- Regulation FD disclosure requirements
The 8-Ks often contain important financial statistics and trading multiples that may not be reflected in the most recent 10-K or 10-Q.
32
What is a proxy statement and what does it contain?
A proxy statement is a document that a public company sends to its shareholders prior to a shareholder meeting containing material information regarding matters on which the shareholders are expected to vote. It is also filed with the SEC on Schedule 14A. It also may provide basic share outstanding counts that may be more recent than that contained in the 10-Q or 10-K.
33
What are equity research reports and what do they contain?
Equity research reports provide individual analyst estimates of future company performance, which may be used to calculate forward-looking multiples, including estimates of sales, EBITDA and/or EBIT and EPS for future quarters (and future 2,3 year period). The reports may also provide commentary on non-recurring items and recent M&A and capital market transactions, which are helpful for determining pro forma adjustments and normalizing financial data.
34
What are consensus estimates and what do they contain?
Consensus estimates for selected financial statistics are widely used by bankers as the basis for calculating forward-looking trading multiples in trading comps. Primary estimates are First Call and IBES, found through Bloomberg, FactSet, and Thomson Reuters. Typically a banker chooses one source to maintain consistency throughout the analysis.
35
What is a press release and what does it contain?
A company issues a press release when it has something important to report to the public, including earnings announcements, declaration of dividends, and management changes, as well as M&A and capital markets transactions.
36
What sources can I use to find income statement data such as: Sales, Gross Profit, EBITDA, EBIT, Net Income, EPS
Most recent 10-K, 10-Q, 8-K, and press releases
37
What source can I use to find research estimates?
First Call or IBES, individual equity research reports
38
What source can I use to find Balance Sheet data such as : Cash Balance, Debt Balances, Shareholders' Equity?
Most recent 10-K, 10-Q, 8-K, and press releases
39
What source can I use to find Cash Flow Statement data such as : Depreciation and Amortization, Capital Expenditures?
Most recent 10-K, 10-Q, 8-K, and press releases
40
What source can I use to find Share Data such as Basic Shares Outstanding?
10-K, 10-Q, or Proxy Statement, whichever is most recent
41
What source can I use to find Share Data such as Options and Warrant Data?
10-K or 10-Q, whichever is most recent
42
What source can I use to find market data such as Share Price Data?
Financial Information services such as Bloomberg
43
What source can I use to find credit ratings?
Rating agencies' websites, Bloomberg
44
What are the key metrics to use when looking at a size (market valuation)?
Equity value and Entreprise value: Key Financial Data: sales, gross profit, EBITDA, EBIT, and net income
45
What are the key metrics to consider when looking at profitability?
Gross profit, EBITDA, EBIT, and net income margins
46
What are the key metrics to consider when looking at growth profile?
Historical and estimated growth rates
47
What are the key metrics to consider when looking at Return on Investment?
ROIC, ROE, ROA, and dividend yield
48
What are the key metrics to consider when looking at Credit Profile?
Leverage ratios, coverage ratios, and credit ratings
49
What is Equity Value?
Equity Value, or market capitalization, is the value represented by a given company's basic shares outstanding plus 'in the money' stock options, warrants, and convertible securities - collectively fully diluted shares outstanding.
50
What is the formula for Equity Value?
{Share Price} x {Fully Diluted Shares Outstanding}
Fully Diluted Shares Outstanding =
{Basic Shares outstanding
+ in-the-money options and warrants
+ in-the-money convertible securities}
51
What does Equity Value represent?
It represents the market capitalization of the firm available to shareholders. Equity Value is the Enterprise Value minus Net Debt so it is the residual value that remains after satisfying the debt obligations of the firm.
52
What does Equity Value highlight when compared to other firms and what else can we use with it for more perspective?
Equity Value provides a measure of relative size to other companies, therefore, for insight on absolute AND relative size, the banker can look at the company's current share price as a percentage of its 52-week high. This provides a perspective on valuation and gauges the current market sentiment and outlook both for the individual company and its broader sector.
53
How do you calculate Fully Diluted Shares Outstanding?
A company's fully diluted shares outstanding are calculated by adding the number of shares represented by its in-the-money options, warrants, and convertible securities to its basic shares outstanding. Incremental shares represented by a company's in-the-money options and warrants are calculated in accordance with the treasury stock method (TSM). Shares implied by a company's in-the-money convertible and equity-linked securities are calculated with the if-converted method or net share settlement (NSS).
54
What is the Treasury Stock Method
The TSM assumes that all the groups of in-the-money options and warrants are exercised at their weighted average strike price with the resulting option proceeds used to repurchase outstanding shares of stock at the company's current share price. In-the-money options and warrants are those that have an exercise price lower than the current market price of the underlying company's stock. Since the strike price is lower than the market price, the number of shares repurchased is less than the additional shares outstanding from exercised options thus the net issuance of shares is dilutive.
55
Assume:
Current Share Price: $20
Basic Shares Outstanding: 100
In-the-money Options: 5
Weighted Average Exercise Price: $18
Talk me through what happens.
With 5million shares in the money, at an $18 exercise price (lower than the $20 current price), the holders of the options can buy shares at $18 and sell at $20, realising $2 in differential. Under the TSM, the company purchases shares with the dollar generated from the exercised options ($18 x 5million = $90M). Now, with the $90M on hand, the company purchases shares at market price of $20 = $90M/$20 = 4.5 million shares. The net new shares is the 5 million options less the 4.5 million repurchased = 0.5million. These shares are added to the basic shares outstanding to derive fully diluted shares of 100.5M.
56
What are some types of convertible and equity-linked securities?
Convertible and equity-linked securities bridge the gap between traditional debt and equity, and include instruments such as cash-pay convertible bonds, convertible hybrids, perpetual convertible preferred, and mandatory convertibles.
57
What is a cash-pay convertible bond (convert)?
A convert is a straight debt instrument and an embedded equity call option that provides for the convert to be exchanged for a defined number of shares of the issuer's common stock under certain circumstances. The value of the embedded call option allows the issuer to pay a lower coupon than a straight debt instrument of the same credit. The strike price (conversion price) represents the share price at which equity would be issued to the bondholders if the bonds were converted and is typically set at a premium to the company's underlying share price at the time of issuance.
If the converts are out-of-the-money, they remain treated as debt.
58
What is the If-Converted method?
When performing trading comps, in-the-money converts are converted into additional shares by dividing the convert's amount outstanding by its conversion price. Once converted, the convert is treated as equity and included in the calculation of the company's equity value.
59
Assume:
Company's current share price: $20
Amount Outstanding for convertibles: $150
Conversion Price: $15
How many extra shares from convertibles are produced using the If-Converted Method?
First, we notice that the convertibles are in-the-money, with a conversion price of $15 which is less than the current share price of $20. Next, we calculate the number of shares converted from the convertibles. Since the value of the convertibles is $150 and we have a conversion price of $15, we simply calculate new shares by dividing the amount outstanding by the conversion price, 150/15 = 10 new shares from conversion.
60
Does converting in-the-money convertible debt affect anything else?
Yes, the conversion of in-the-money converts also requires an upward adjustment to the company's net income to account for the foregone interest expense payment associated with the coupon on the convert. This amount is tax-effected before being added back to net income. Therefore, while conversion is typically dilutive for EPS (due to shares issued), net income is actually higher on a pro forma basis.
61
What is the Net Share Settlement method?
For the Net Share Settlement method, the issuer is permitted to satisfy the face (or accreted) value of an in-the-money convert with cash upon conversion. Thus, only the value represented by the excess of the current share price over the conversion price is assumed to be settled with the issuance of additional shares, resulting in fewer shares issued.
62
What does the NSS serve to do?
The NSS serves to limit the dilutive effects of conversion by affording the issuer Treasury Stock Method accounting treatment.
63
Assume:
Company's current share price: $20
Amount Outstanding for convertibles: $150
Conversion Price: $15
How many extra shares from convertibles are produced using the Net Share Settlement method?
Similarly to before, the initial incremental shares are 10 (150/15).
Next, we value the convert to the company ($ amount received through conversion) by multiplying the number of shares by the current share price: $20 x 10 = $200 received. Following this, we pay the outstanding convertible amount of $150, offering an excess over par value of $50. Lastly, we repurchase $50 of current shares (at $20 each), resulting in a net share settlement of 2.5 additional shares.
64
What is Enterprise Value?
Enterprise Value (EV, total enterprise value, or firm value) is the sum of all the ownership interests in a company and claims on its assets from both debt and equity holders.
65
What is the formula for Enterprise Value?
Enterprise Value =
```
Equity Value
+ Total Debt
+ Preferred Stock
+ Noncontrolling Interests
- Cash and Cash Equivalents
```
66
Is Enterprise value independent of capital structure?
Theoretically, yes. Changes to the capital structure of a firm do not affect its enterprise value.
If a company raises additional debt, that is held on the balance sheet as cash, its enterprise value remains constant as the new debt is offset by the increase in cash.
If a company issues equity and uses the proceeds to raise debt, the incremental value is offset by the decrease in debt on a dollar-for-dollar basis.
67
Should similar companies share common enterprise value multiples?
Yes similar companies would be expected to have consistent enterprise value multiples despite differences in capital structure as most debt, equity, and cash issuances are enterprise value neutral. One exception concerns highly levered companies, which may trade at a discount relative to peers due to perceived higher risk of financial distress and potential growth constraints. These are circumstances whereby a company is unable to or struggles to meet its credit obligations, typically resulting from business disruption, insolvency, or bankruptcy. As a perceived risk of financial distress, equity value generally decreases.
68
Talk to me about EBITDA.
EBITDA is earnings before interest, tax, depreciation, and amortization and is an important measure of profitability. EBITDA is non-GAAP and therefore calculated by taking EBIT (or Operating Income) and adding back Depreciation and Amortization as per the Cash Flow Statement. It is a proxy for operating cash flow as it reflects the company's cash operating costs for producing products and services. It also is a fair comparison among companies in the same sector as it is free from differences resulting from Capital Structure (interest expense) and tax regime (tax expense).
69
Why is EBIT less useful than EBITDA at times?
EBIT is found in SEC filings as Income from Operations. It is useful since it is independent from tax regime and capital structure, however is less indicative as measure of operating cash flow (than EBITDA) because it includes non-cash D&A expense, which often reflects discrepancies among companies in capital spending and depreciation policy and acquisition histories.
Also, EBIT may differ from Operating Income by including other income generated by the company out of its typical scope.
70
What is Net Income, conceptually?
Net Income is the residual profit after all of the company's expenses have been netted out. It is the earnings available to all equity holders once other obligations have been satisfied. This can be viewed on a per share basis, EPS.
71
What is gross profit margin and why is it useful?
Gross Profit Margin = [ {Sales - COGS} / Sales ]
It measures the % of sales remaining after subtracting COGS. It is driven by a company's cost per unit, which are often variable.
72
What is EBIT(DA) margin and why is it useful?
EBIT(DA) margin measures a company's operating profitability and is used to frame relative performance among peer companies and across sectors.
EBITDA Margin = EBITDA / Sales
EBIT Margin = EBIT / Sales
73
What is Net Income Margin and why is it used?
Net income margin measures a company's overall profitability.
Net Income Margin = Net Income / Sales
1. It is net of interest expense, and therefore, affected by capital structure of the company. As a result, companies with similar operating margins may have substantially different net income margins due to differences in leverage.
2. Moreso, net income is affected by taxes so companies with similar operating margins may have varying net income margins due to tax rates.
74
What rates do bankers consider when looking at a company's growth profile?
Typically to assess growth, a banker looks at historical and estimated future growth rates as well as annual growth rates (CAGR) for selected financial statistics (such as EPS).
75
What is ROIC and why do we use it?
Return on Invested Capital (ROIC) measures the return generated by all provided to a company. As a result, ROIC utilizes a pre-interest earnings statistic in the numerator (EBIT, or tax-effected EBIT (NOPAT)) and a metric that captures both debt and equity in the denominator. The denominator is typically an average of the balances of the prior annual and most recent periods.
ROIC = EBIT / {Average Net Debt + Equity }
76
What is ROE and why do we use it?
Return on Equity (ROE) measures the return generated on the equity provided to a company by its shareholders. As a result, ROE incorporates earnings net of interest expense, such as Net Income, in the numerator and the average shareholders' equity in the denominator. ROE is an important indicator of performance as companies are focused on shareholder returns.
ROE = Net Income / Average Shareholders' Equity
77
What is ROA and why do we use it?
Return on Assets (ROA) measures the return generated by a company's asset base, providing a barometer of the asset efficiency of a business. It typically utilizes Net Income in the numerator and average of total assets in the denominator.
ROA = Net Income / Average Total Assets
78
What is Dividend Yield and why do we use it?
Dividend Yield is a measure of returns to shareholders. It measures the annual dividends per share paid by a company to its shareholders, expressed as a % of its share price. Dividends are typically paid on a quarterly basis and therefore must be annualized to calculate the implied dividend yield.
Implied Dividend Yield =
Most Recent Quarterly Dividend per Share x 4 / {Current Share Price}
79
What is leverage and how does it affect a company?
Leverage refers to a company's debt level. It is typically measured as a multiple of EBITDA (debt-to-EBITDA) or as a % of total capitalization. Both debt and equity investors track leverage as it reveals the company's financial policy, risk profile, and capacity for growth.
80
Generally, what does higher leverage mean?
The higher the leverage, the higher the risk for financial distress due to the burden associated with greater interest expense and principal repayments.
81
What does Debt-to-EBITDA tell us?
Debt-to-EBITDA depicts the ratio of a company's debt to its EBITDA, calculated on a Last Twelve Multiples statistic. High multiples connotate higher leverage.
Leverage = Debt / EBITDA
There are variations of this ratio, including:
1. total debt-to-EBITDA
2. senior secured debt-to-EBITDA
3. net debt-to-EBITDA
4. total debt-to-(EBITDA less capex)
This is used as EBITDA is a rough proxy for operating cash flow, viewed as a measure of how many years a company's cash flows are needed to repay its debt
82
What does Debt-to-Total-Capitalization measure?
Debt-to-Total-Capitalization measures a company's debt as a % of its (Debt + preferred stock + noncontrolling interest + equity). The ratio can be calculated on the basis of book or market value. Higher multiples connote higher levels and risk of financial distress.
Debt-to-Total-Capitalization = Debt / { Debt + Preferred Stock + Noncontrolling Interest + Equity }
83
What is Coverage?
Coverage refers to a company's ability to meet its interest expense obligations. Coverage ratios are generally a financial statistic representing operating cash flow (LTM EBITDA) and the LTM interest expense in the denominator. Higher multiples indicate better positioning to cover interest expense and thus a higher credit profile.
There are several types of coverage statistic:
1. EBITDA-to-interest expense
2. (EBITDA less Capex)-to-Interest Expense
3. EBIT-to-interest Expense
Interest Coverage Ratio:
EBITDA or (EBITDA -Capex) or EBIT / Interest Expense
84
What is a company's credit rating? What's the higher credit rating available?
A credit rating is an assessment by an independent rating agency of a company's ability and willingness to make full and timely payments of amounts due on its debt obligations.
3 major rating agencies exist with slightly different rating scales. Typically Aaa, AAA are the highest quality.
85
What's the thresh hold for investment and non-investment grade ratings?
Typically around Baa3, BBB- are medium grade investments and the thresh hold for non-investment grade ratings.
86
How do I calculate LTM Financial Data?
LTM = Prior Fiscal Year + Current Stub - Prior Stub
87
What is calendarization? Why do we use it?
The majority of US public filers report their financial performance in accordance with a fiscal year ending Dec 31, however, some companies report on a different schedule. Any variation in fiscal year ends among comparable companies must be addressed for benchmarking purposes, otherwise trading multiples will be based on financial data for different periods and not truly comparable.
88
How do we calendarize?
Next Calendar Year Sales =
{(Month #) x (Actual Fiscal Year Sales) / 12}
+ {(12-Month#) x (Next Fiscal Year Sales) / 12}
89
What is scrubbing or sanitizing?
Scrubbing or sanitizing the financials means to adjust reported financial data for non-recurring items.
90
What happens if you don't scrub the data?
Failure to scrub the data may lead to the calculation of misleading ratios and multiples which in turn produce distorted valuations.
91
What are some charges/benefits that are adjusted due to scrubbing?
Charges adjusted:
- Restructuring events (store/plant closures), headcount reduction
- Losses on asset sales
- Changes in accounting principles
- Inventory write-offs
- Goodwill impairments
- Extinguishment of debt
- Losses from litigation settlements
Benefits adjusted:
- gains from asset sales
- favorable litigation settlements
- tax adjustments
92
Where do you find the information on non-recurring charges?
Non-recurring items are often described in the MD&A section and financial footnotes in a company's public filings and earnings announcements
93
Why do you have to take precaution with non-recurring items?
Often, items which seem non-recurring for one company may be a regular item for another. For example, pharmaceutical companies may find themselves in court frequently due to lawsuits and thus this should not be considered non-recurring.
94
Should bankers make other adjustments to normalize company financials (other than calendarization and scrubbing)?
Bankers must also adjust for recent events, such as M&A transactions, financing activities, conversion of convertible securities, stock splits, share repurchases in between reporting periods.
95
What is the format for most trading multiples?
A measure of market valuation (enterprise value, equity value) is in the numerator.
A universal measure of financial performance in the denominator (EBITDA, net income).
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What is the format for enterprise value multiples?
For enterprise value multiples, the denominator employs a financial statistic that flows to both debt AND equity holders (Sales, EBITDA, EBIT)
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What is the format for equity value multiples?
For equity value (or share price) multiples, the denominator must be a financial statistic that flows to equity holders only (Net Income, or Diluted EPS).
98
What are the most common multiples used?
EV/EBITDA and P/E
99
What are some Equity Value multiples?
P/E multiple - headline ratio, how many years earnings it will take for the investor to recover the price paid for the shares. All else equal, investors should prefer lowest P/E multiples.
P/BV multiple: useful measure when tangible assets are source of value generation. Close link to return on equity (P/BV = {P/E * ROE}, it is useful to view price to book together with ROE.
P/Sales: useful when a company is loss-making or margins are uncharacteristically low (distressed firms)
PEG: PEG ratio used to determine stock's value while taking into account earnings growth.
{for each the numerator is equity value price per share
for each the denominator is an operating parameter}
100
What is the Price-to-Earnings ratio?
The P/E ratio, calculated as current share price divided by diluted EPS (Equity Value / Net Income) measures how much investors are willing to pay for a dollar of a company's current or future earnings.
101
What are P/E ratios based on?
P/E ratios are typically based on forward-looking EPS as investors are focused on future growth.
102
What are the limitations of P/E ratios?
P/E is not relevant for companies with little or no earnings as the denominator can be zero or negative.
In addition, Net Income (and EPS) is net of interest expense and therefore dependent on capital structure of the company.
As a result, two companies similar in terms of size and operating margins can have substantially different net income margins (and consequently P/E ratios) due to differences in leverage.
Similarly, accounting discrepancies such as depreciation and tax can produce meaningful disparities in P/E ratios among comparables.
103
Why could two companies, otherwise similar in terms of size and operating margins, have substantially different net income margins or P/E ratios?
In short: Leverage (differing capital structure) as well as accounting treatment.
Net Income (and EPS) is net of interest expense and therefore dependent on capital structure of the company.
Similarly, accounting discrepancies such as depreciation and tax can produce meaningful disparities in P/E ratios among comparables.
104
What is the formula for P/E?
Share Price / Diluted EPS
or Equity Value / Net Income
(both are equivalent, assuming constant share count)
105
What are some common Enterprise Value multiples?
EV/EBITDA - measure that indicates the value of the overall company (not just equity). It is a measure of the cost of a stock, valid for comparing across companies.
EV/EBIT - a better measure of free (post-maintenance capital spending) cash flow than EBITDA and is more comparable where capital intensities differ.
EV/Sales - it's a really crude measure of comparison but it is the least susceptible to accounting differences. It also can be used for aggressively growing technology companies with large sales volume but yet to realise profitability.
106
When would you use EV/EBIT rather than EV/EBITDA
You would use EBIT rather than EBITDA when you want to account for large variations in capital expenditures in a company that would yield large D&A values. Most importantly, this is the case for companies that may lease vs rent their premises and thus have large, varying levels of D&A and lease expenses. EBIT helps reduce the discrepancy.
You can also consider it when you are valuing divisions of companies where no exact D&A figure is available for the division.
107
What is Enterprise Value / EBIT(DA) (or EV/EBIT(DA)) and why is it used?
EV/EBITDA serves as a valuation standard that is independent of capital structure and tax regime of a company, as well as any distortions that may arise from differences in D&A among different companies.
- for example, heavy investment in D&A for current and future years vs deferred capital spending results in a large discrepancy in D&A expenses.
EV/EBIT may be used less frequently also due to acquisition-related amortization
108
What is EV/Sales and why is it used?
EV/Sales is used as a valuation metric, albeit less frequently. Sales can provide an indication of size however this does not translate directly to profitability or cash flow generation, which are true value drivers of valuation.
However, in certain sectors, or for companies with little or no earnings, EV/sales can be meaningful for reference. It could be used to value early stage technology companies that are aggressively growing sales but yet to achieve profitability.
109
What sector would use Enterprise Value / Access Lines (Fiber Miles or Route Miles)?
Telecommunications
110
What sectors would you use Enterprise Value / Broadcast Cash Flow (BCF)
Media
| Telecommunications
111
What sectors would you use Enterprise Value / EBITDAR (r= rent)
Casinos
Restaurants
Retail
112
What sectors would you use Enterprise Value / EBITDAX (x = exploration)
Natural Resources
| Oil&Gas
113
What sectors would you use Enterprise Value / Population
Telecommunications
114
What sectors would you use Enterprise Value / Production (capacity, in units)
Metals & Mining
Natural Resources
Oil&Gas
Paper and Forest Products
115
What sectors would you use Enterprise Value / Reserves
Metals & Mining
Natural Resources
Oil & Gas
116
What sectors would you use Enterprise Value / Subscriber
Media
| Telecommunications
117
What sectors would you use Enterprise Value / Square Footage
Real Estate
| Retail
118
What sectors would you use Equity Value / Book Value (per share)
Financial Institutions
| Homebuilders
119
What sectors would you use Equity Value / Cash available for Distribution (per share)
Real Estate
120
What sectors would you use Equity Value / Discretionary Cash Flow
Natural Resources
121
What sectors would you use Equity Value / Funds from Operations
Real Estate
122
What sectors would you use Equity Value / Net Asset Value
Financial Institutions
| Real Estate
123
What are the two steps in Benchmarking?
1. Benchmark the key financial statistics and ratios for the target and its comparables in order to establish relative positioning (in order to find best comparables)
2. Analyze and compare the trading multiples for the peer group
124
How does a banker justify trading multiple ranges?
Typically the banker uses means and medians of the most relevant multiples for the sector and extrapolates a defensible range of multiples from that. The high and low multiples of the comparables universe provide further guidance.
125
How do you calculate share price from the following information:
EBITDA: $200
EV/EBITDA multiple range: 6.5X-7.5X
Net Debt: $500
Fully Diluted Shares: 100
First, we take the financial metric, EBITDA, of $200 and multiply it by the multiple range, 6.5-7.5, to get a range of Enterprise values:
EV = 1300-1500
next, we subtract the net debt, $500, to get the Equity Value implied:
Equity Value= 800-1000
lastly, we divide the Equity Value by the fully diluted shares (100) to arrive at a trading range for the share price:
$8.0-$10.0
126
How do you find the implied share price from P/E?
With P/E multiple ranges, you multiply the financial statistic, Net Income, by the multiple range, and divide by the Fully Diluted Shares to arrive at implied share price.
127
How do you calculate Enterprise Valuation implied by P/E from the follow information:
Net Income: $70
P/E Multiple range: 12X-15X
Net Debt: $500
Multiply the financial metric, net income, by the P/E multiple range, to arrive at the Implied Equity Value
$70 * (12X-15X) = $840 - $1,050
Add the net debt (any obligations senior to common equity) of $500
Implied EV = $1,340 - $1,550
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What is the final step of justifying valuation ranges from a comparable companies analysis?
The banker should compare the valuation derived to other methodologies such as:
Precedent Transactions
DCF Analysis
LBO Analysis
129
What are some common errors in trading comps?
Inclusion or over-emphasis of inappropriate comparable companies, incorrect calculations (fully-diluted equity value, enterprise value, LTM financial data, calendarization), as well as failure to scrub financials for non-recurring items and recent events
130
What are the PROS for Comparable Companies Analysis?
MARKET BASED: information used to derive valuation for the target is based on actual public market data, thereby reflecting the market's growth and risk expectations, as well as overall sentiment
RELATIVITY: easily measurable and comparable versus other companies
QUICK AND CONVENIENT: valuation can be determined on the basis of a few easy-to-calculate inputs
CURRENT: valuation is based on prevailing market data, which can be updated on a daily basis
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What are the CONS for Comparable Companies Analysis?
MARKET-BASED: valuation that is completely market-based can be skewed during periods of irrational exuberance or bearishness
ABSENCE OF RELEVANT COMPARABLES: "pure-play" comparables may be difficult to identify or even non-existent, especially if the target operates in a niche sector in which case the valuation implied by the trading comps may be less meaningful
POTENTIAL DISCONNECT FROM CASH FLOW: valuation based on prevailing market conditions or expectations may have significant disconnect from the valuation implied by a company's projected cash flow generation
COMPANY-SPECIFIC ISSUES: valuation of the target is based on the valuation of other companies, which may fail to capture target-specific strengths, weaknesses, opportunities, and risks
132
What sector would use Enterprise Value / Broadcast Cash Flow
Telecommunications
| Media
133
What sector would use Enterprise Value / EBITDAR
| R = rent expense
Casinos
Restaurants
Retail
134
What sector would use Enterprise Value / EBITDAX
| X = Exploration Expense
Natural Resources
| Oil and Gas
135
What sector would use Enterprise Value / Population (POP)
Telecommunications
136
What sector would use Enterprise Value / Production (or Capacity units)
Metals & Mining
Natural Resources
Oil and Gas
Paper and Forestry Products
137
What sector would use Enterprise Value / Reserves
Metals & Mining
Natural Resources
Oil & Gas
138
What sector would use Enterprise Value / Subscribers
Media
| Telecommunications
139
What sector would use Enterprise Value / Square Footage
Real Estate
| Retail
140
What sector would use Equity Value / Book Value (per share)
Financial Institutions
| Homebuilders
141
What sector would use Equity Value / Cash Available for Distribution (per share)
Real Estate
142
What sector would use Equity Value / Discretionary Cash Flow (per share)
Natural Resources
143
What sector would use Equity Value / Funds from Operations (FFO) per share
Real Estate
144
What sector would use Equity Value / Net Asset Value (per share)
Financial Institutions
| Real Estate
