Valuation & DCF Analysis

Question 1

What’s the point of valuation? WHY do you value a company?

Answer 1

You value a company to determine its Implied Value according to your views of it. If this Implied Value is very different from the company’s Current Value, you might be able to invest in the company and make money if its value changes. If you are advising a client company, you might value it so you can tell management the price that it might receive if the company sells, which is often different from its Current Value.

Question 2

But public companies already have Market Caps and Share Prices. Why bother valuing them?

Answer 2

Because a company’s Market Cap and Share Price reflect its Current Value according to “the market as a whole” – but the market might be wrong! You value companies to see if the market’s views are correct or incorrect.

Question 3

What are the advantages and disadvantages of the 3 main valuation methodologies?

Answer 3

Public Comps are useful because they’re based on real market data, are quick to calculate and explain, and do not depend on far-in-the-future assumptions. However, there may not be truly comparable companies, the analysis will be less accurate for volatile or thinly traded companies, and it may undervalue companies’ long-term potential. Precedent Transactions are useful because they’re based on the real prices that companies have paid for other companies, and they may better reflect industry trends than Public Comps. However, the data is often spotty and misleading, there may not be truly comparable transactions, and specific deal terms and market conditions might distort the multiples. DCF Analysis is the most “correct” methodology according to finance theory, it’s less subject to market fluctuations, and it better reflects company-specific factors and long-term trends. However, it’s also very dependent on far-in-the-future assumptions, and there’s disagreement over the proper calculations for key figures like the Cost of Equity and WACC.

Question 4

Which of the 3 main methodologies will produce the highest Implied Values?

Answer 4

This is a trick question because almost any methodology could produce the highest Implied Values depending on the industry, time period, and assumptions. Precedent Transactions often produce higher Implied Values than the Public Comps because of the control premium – the extra amount that acquirers must pay to acquire sellers. But it’s tough to say how a DCF stacks up because it’s far more dependent on your assumptions. The best answer is: “A DCF tends to produce the most variable output since it’s so dependent on your assumptions, and Precedent Transactions tend to produce higher values than the Public Comps because of the control premium.”

Question 5

When is a DCF more useful than Public Comps or Precedent Transactions?

Answer 5

You should pretty much always build a DCF since it IS valuation – the other methodologies are supplemental. But it’s especially useful when the company you’re valuing is mature and has stable, predictable cash flows, or when you lack good Public Comps or Precedent Transactions.

Question 6

When are Public Comps or Precedent Transactions more useful than the DCF?

Answer 6

If the company you’re valuing is early-stage, and it is impossible to estimate its future cash flows, or if the company has no path to positive cash flows, you have to rely on the other methodologies. These other methodologies can also be more useful when you run into problems in the DCF, such as an inability to estimate the Discount Rate or extremely volatile cash flows.

Question 7

Which one should be worth more: a $500 million EBITDA healthcare company or a $500 million EBITDA industrials company? Assume the growth rates, margins, and all other financial stats are the same.

Answer 7

In all likelihood, the healthcare company will be worth more because healthcare is a less asset-intensive industry. That means the company’s CapEx and Working Capital requirements will be lower, and its Free Cash Flow will be higher (i.e., closer to EBITDA) as a result. Healthcare, at least in some sectors, also tends to be more of a “growth industry” than industrials. The Discount Rate might also be higher for the healthcare company, but the lower asset intensity and higher expected growth rates would likely make up for that. However, this answer is an extreme generalization, so you would need more information to make a real decision.

Question 8

How do you value an apple tree?

Answer 8

The same way you value a company: Comparables and a DCF. You’d look at what similar apple trees have sold for, and then calculate the expected future cash flows from this tree. You would then discount these cash flows to Present Value, discount the Terminal Value to PV, and add up everything to determine the apple tree’s Implied Value. The Discount Rate would be based on your opportunity cost - what you might be able to earn each year by investing in other, similar apple trees.

Question 9

People say that the DCF is an intrinsic valuation methodology, while Public Comps and Precedent Transactions are relative valuation. Is that correct?

Answer 9

No, not exactly. The DCF is based on the company’s expected future cash flows, so in that sense, it is “intrinsic valuation.” But the Discount Rate used in a DCF is linked to peer companies (market data), and if you use the Multiples Method to calculate Terminal Value, the multiples are also linked to peer companies. The DCF depends less on the market than the other methodologies, but there is still some dependency. It’s more accurate to say that the DCF is more of an intrinsic valuation methodology than the others.

Question 10

Why do you build a DCF analysis to value a company?

Answer 10

You build a DCF analysis because a company is worth the Present Value of its expected future cash flows: Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate. But you can’t just use that single formula because a company’s Cash Flow Growth Rate and Discount Rate change over time. So, in a Discounted Cash Flow analysis, you divide the valuation into two periods: One where those assumptions change (the explicit forecast period) and one where they stay the same (the Terminal Period). You then project the company’s cash flows in both periods and discount them to their Present Values based on the appropriate Discount Rate(s). Then, you compare this sum – the company’s Implied Value – to the company’s Current Value or “Asking Price” to see if it’s valued appropriately.

Question 11

Walk me through a DCF Analysis.

Answer 11

A DCF values a company based on the Present Value of its Cash Flows in the explicit forecast period plus the Present Value of its Terminal Value. You start by projecting the company’s Free Cash Flows over the next 5-10 years by making assumptions for revenue growth, margins, Working Capital, and CapEx. Then, you discount the cash flows using the Discount Rate, usually the Weighted Average Cost of Capital, and sum up everything. Next, you estimate the company’s Terminal Value using the Multiples Method or the Gordon Growth Method; it represents the company’s value after those first 5-10 years into perpetuity. You then discount the Terminal Value to Present Value using the Discount Rate and add it to the sum of the company’s discounted cash flows. Finally, you compare this Implied Value to the company’s Current Value, usually its Enterprise Value, and you’ll often calculate the company’s Implied Share Price so you can compare it to the Current Share Price.

Question 12

How do you move from Revenue to Free Cash Flow in a DCF?

Answer 12

First, confirm that the interviewer is asking for Unlevered Free Cash Flow (AKA Free Cash Flow to Firm). If so: Subtract COGS and Operating Expenses from Revenue to reach Operating Income (EBIT). Then, multiply Operating Income by (1 - Tax Rate), add back Depreciation & Amortization, and factor in the Change in Working Capital. If the company spends extra cash as it grows, the Change in Working Capital will be negative; if it generates extra cash flow as a result of its growth, it will be positive. Finally, subtract Capital Expenditures to calculate Unlevered Free Cash Flow. Levered Free Cash Flow (Free Cash Flow to Equity) is similar, but you subtract the Net Interest Expense before multiplying by (1 - Tax Rate), and you also factor in changes in Debt principal.

Question 13

What does the Discount Rate mean?

Answer 13

The Discount Rate represents the opportunity cost for the investors – what they could earn by investing in other, similar companies in this industry. A higher Discount Rate means the risk and potential returns are both higher; a lower Discount Rate means lower risk and lower potential returns. A higher Discount Rate makes a company less valuable because it means the investors have better options elsewhere; a lower Discount Rate makes a company more valuable.

Question 14

How do you calculate Terminal Value in a DCF, and which method is best?

Answer 14

You can use the Multiples Method or the Gordon Growth Method (AKA Long-Term Growth Method, Perpetuity Growth Method, etc.). With the first one, you apply a Terminal Multiple to the company’s EBITDA, EBIT, NOPAT, or FCF in the final year of the forecast period. For example, if you apply a 10x EV / EBITDA multiple to the company’s Year 10 EBITDA of $500, its Terminal Value is $5,000. With the Gordon Growth Method, you assign a “Terminal Growth Rate” to the company’s Free Cash Flows in the Terminal Period and assume they’ll grow at that rate forever. Terminal Value = Final Year Free Cash Flow * (1 + Terminal Growth Rate) / (Discount Rate – Terminal Growth Rate) The Gordon Growth Method is better because growth always slows down over time; all companies’ cash flows eventually grow more slowly than GDP. If you use the Multiples Method, it’s easy to pick a multiple that makes no logical sense because it implies a growth rate that’s too high. However, many bankers still use and prefer the Multiples Method because it’s “easier” or because they don’t understand the need to cross-check the output.

Question 15

What are some signs that you might be using the incorrect assumptions in a DCF?

Answer 15

The most common signs of trouble are: 1. Too Much Value from the PV of Terminal Value – It usually accounts for at least 50% of the company’s total Implied Value, but it shouldn’t account for, say, 95% of its value.

2. Implied Terminal Growth Rates or Terminal Multiples That Don’t Make Sense – If you pick a Terminal Multiple that implies a Terminal FCF Growth Rate of 8%, but the country’s long-term GDP growth rate is 3%, something is wrong.
3. You’re Double-Counting Items – If an income or expense line item is included in FCF, you should not count the corresponding Asset or Liability in the Implied Enterprise Value  Implied Equity Value “bridge” at the end. And if a line item is excluded from FCF, you should count the corresponding Asset or Liability in the “bridge” at the end.
4. Mismatched Final Year FCF Growth Rate and Terminal Growth Rate – If the company’s Free Cash Flow is growing at 15% in the final year, but you’ve assumed a 2% Terminal Growth Rate, something is wrong. FCF growth should decline over time and approach the Terminal Growth Rate by the end of the explicit forecast period.

Question 16

If your DCF seems off, what are the easiest ways to fix it?

Answer 16

The simplest method is to extend the explicit forecast period so that the company’s Free Cash Flow contributes more value, and so that there’s more time for FCF growth to slow down and approach the Terminal Growth Rate. So, if you’re using a 5-year forecast period, extend it to 10-15 years and reduce the company’s FCF growth in those extra years as it approaches maturity. To avoid double-counting items… look at what you’re doing and don’t double count! Finally, you can reduce the Terminal Value by picking a lower Terminal Growth Rate or lower Terminal Multiple. Terminal Value tends to be overstated in financial models because people don’t understand the theory behind it.

Question 17

How do you interpret the results of a DCF?

Answer 17

You compare the company’s Implied Enterprise Value, Equity Value, or Share Price to its Current Enterprise Value, Equity Value, or Share Price to see if it might be overvalued or undervalued. You do this over a range of assumptions because investing is probabilistic. For example, if you believe that the company’s Implied Share Price is between $15.00 and $20.00, but its Current Share Price is $8.00, then that is good evidence that the company may be undervalued. But if its Current Share Price is $17.00, then it may be valued appropriately.

Question 18

Does a DCF ever make sense for a company with negative cash flows?

Answer 18

Yes, it may. A DCF is based on a company’s expected future cash flows, so even if the company is cash flow-negative right now, the analysis could work if it starts generating positive cash flows in the future. If the company has no path to positive cash flows, or you can’t reasonably forecast its cash flows, then the analysis doesn’t make sense.

Question 19

How do the Levered DCF Analysis and Adjusted Present Value (APV) Analysis differ from the Unlevered DCF?

Answer 19

In a Levered DCF, you use Levered FCF for the cash flows and Cost of Equity for the Discount Rate, and you calculate Terminal Value using Equity Value-based multiples such as P / E. You don’t back into Implied Equity Value at the end because the analysis produces the Implied Equity Value directly. An APV Analysis is similar to a traditional Unlevered DCF, but you value the company’s Interest Tax Shield separately and add the Present Value of this Tax Shield at the end. You still calculate Unlevered FCF and Terminal Value in the same way, but you use Unlevered Cost of Equity for the Discount Rate (i.e., Risk-Free Rate + Equity Risk Premium * Median Unlevered Beta from Public Comps). You then project the Interest Tax Shield each year, discount it at that same Discount Rate, calculate the Interest Tax Shield Terminal Value, discount it, and add up everything at the end.

Question 20

Will you get the same results from an Unlevered DCF and a Levered DCF?

Answer 20

No. The simplest explanation is that an Unlevered DCF does not factor in the interest rate on the company’s Debt, while the Levered DCF does. That alone will create differences, but the volatile cash flows in a Levered DCF (due to changes in Debt principal) will also contribute; it’s very difficult to pick “equivalent assumptions” in both analyses.

Question 21

Why do you typically use the Unlevered DCF rather than the Levered DCF or APV Analysis?

Answer 21

The traditional Unlevered DCF is easier to set up, forecast, and explain, and it produces more consistent results than the other methods. With the other methods, you have to project the company’s Cash and Debt balances, Net Interest Expense, and changes in Debt principal, all of which require more time and effort. The Levered DCF sometimes produces odd results because Debt principal repayments can spike the Levered FCF up or down in individual years. The APV Analysis is flawed because it doesn’t factor in the main downside of Debt: Increased chances of bankruptcy. You can try to reflect this risk, but no one agrees on how to estimate it numerically. The Unlevered DCF solves this issue because WACC decreases with additional Debt, at first, but then starts increasing past a certain level, which reflects both the advantages and disadvantages of Debt.

Question 22

Why do you calculate Unlevered Free Cash Flow by including and excluding various items on the financial statements?

Answer 22

Unlevered FCF must capture the company’s core, recurring line items that are available to ALL investor groups. That’s because Unlevered FCF corresponds to Enterprise Value, which also represents the value of the company’s core business available to all investor groups. So, if an item is NOT recurring, NOT related to the company’s core business, or NOT available to all investor groups, you leave it out. This rule explains why you exclude all of the following items: • Net Interest Expense – Only available to Debt investors. • Other Income / (Expense) – Corresponds to non-core-business Assets. • Most non-cash adjustments besides D&A – They’re non-recurring. • All Items in Cash Flow from Financing – They’re only available to certain investors. • Most of Cash Flow from Investing – Only CapEx is a recurring, core-business item.

Question 23

How does the Change in Working Capital affect Free Cash Flow, and what does it tell you about a company’s business model.

Answer 23

The Change in Working Capital tells you whether the company generates more cash than expected as it grows, or whether it requires more cash to fuel that growth. It’s related to whether a company records expenses and revenue before or after paying or collecting them in cash. For example, retailers tend to have negative values for the Change in Working Capital because they must pay for Inventory upfront before they can sell products. But subscription-based software companies often have positive values for the Change in Working Capital because they collect cash from long-term subscriptions upfront and recognize it as revenue over time. The Change in WC could increase or decrease the company’s Free Cash Flow, but it’s rarely a major value driver because it’s fairly small for most companies.

Question 24

Should you add back Stock-Based Compensation to calculate Free Cash Flow? It’s a non-cash add-back on the Cash Flow Statement?

Answer 24

No! You should consider SBC a cash expense in the context of valuation because it creates additional shares and dilutes the existing investors. By contrast, Depreciation & Amortization relate to timing differences: The company paid for a capital asset earlier on but recognizes that payment over many years. Stock-Based Compensation is a non-cash add-back on the Cash Flow Statement, but the context is different: Accounting rather than valuation. In a DCF, you should count SBC as a real cash expense or, if you count it as a non-cash add-back, you should reflect the additional shares by increasing the company’s diluted share count, which will reduce the Implied Share Price. Most DCFs get this completely wrong because they use neither approach: They pretend that SBC is a normal non-cash charge that makes no impact on the share count (wrong!).

Question 25

What’s the proper tax rate to use when calculating FCF - the effective tax rate, the statutory tax rate, or the cash tax rate?

Answer 25

The company’s Free Cash Flows should reflect the cash taxes it pays. So, it doesn’t matter which rate you use as long as the cash taxes are correct. For example, you could use the company’s effective tax rate (Income Statement Taxes / Pre-Tax Income), and then include Deferred Taxes within the non-cash adjustments. Or you could calculate and use the company’s “cash tax rate” and skip the Deferred Tax adjustments. You could even use the statutory tax rate and make adjustments for state/local taxes and other items to arrive at the company’s real cash taxes. It’s most common to use the effective tax rate and then adjust for Deferred Taxes based on historical trends.

Question 26

How should CapEx and Depreciation change within the explicit forecast period?

Answer 26

Just like the company’s Free Cash Flow growth rate should decline in the explicit forecast period, the company’s CapEx and Depreciation should also decline. High-growth companies tend to spend more on Capital Expenditures to support their growth, but this spending declines over time as the companies move from “growth” to “maintenance.” If the company’s FCF is growing, CapEx should always exceed Depreciation, but there may be less of a difference by the end. Also, if the company’s FCF is growing, CapEx should not equal Depreciation – even in the Terminal Period. That’s partially due to inflation (capital assets purchased 5-10 years ago cost less), and partially because Net PP&E must keep growing to support FCF Growth in the Terminal Period. If you’re assuming that the company’s FCF stagnates or declines, then you might use different assumptions.

Question 27

Should you reflect inflation in the FCF projections?

Answer 27

In most cases, no. Clients and investors tend to think in nominal terms, and assumptions for prices and salaries tend to be based on nominal figures. If you reflect inflation, then you also need to forecast inflation far into the future and adjust all figures in your analysis. That’s rarely worthwhile because of the uncertainty, extra work, and extra explanations required.

Question 28

If the company’s capital structure is expected to change, how do you reflect it in FCF?

Answer 28

You’ll reflect it directly in a Levered DCF because the company’s Net Interest Expense and Debt principal will change over time. You’ll also change the Cost of Equity over time to reflect this. The changing capital structure won’t show up EXPLICITLY in Unlevered FCF, but you will still reflect it in the analysis with the Discount Rate - WACC will change as the company’s Debt and Equity levels change.

Question 29

What’s the relationship between including an income or expense line item in FCF and the Implied Equity Value calculation at the end of the DCF?

Answer 29

If you include an income or expense line item in Free Cash Flow, then you should exclude the corresponding Asset or Liability when moving from Implied Enterprise Value to Implied Equity Value at the end (and vice versa for items you exclude). For example, if you capitalize the company’s operating leases and count them as a Debt-like item at the end, then you should exclude the rental expense from FCF, making it higher. This rule also explains why you factor in Cash and Debt when moving to the Implied Equity Value in an Unlevered DCF: You’ve excluded the corresponding items on the Income Statement (Interest Income and Interest Expense).

Question 30

How do Net Operating Losses (NOLs) factor into Free Cash Flow?

Answer 30

You could set up an NOL schedule and apply the NOLs to reduce the company’s cash taxes, also factoring in NOL accruals if the company earns negative Pre-Tax Income. If you do this, then you don’t need to count the NOLs in the Implied Enterprise Value  Implied Equity Value calculation at the end. However, it’s far easier to skip that separate schedule and add NOLs as a non-core-business Asset in this calculation at the end. Beyond the extra work, one problem with the first approach is that the company may not use all of its NOLs by the end of the explicit forecast period!

Question 31

How does the Pension Expense factor into Free Cash Flow?

Answer 31

There are different components of the Pension Expense, including the Service Cost, the Interest Expense, the Expected Return on Plan Assets, the Amortization of Net Losses or Gains, and Other Adjustments. The Service Cost is an operating expense and should always be included in the company’s Free Cash Flow. In an Unlevered DCF, you exclude the Interest Expense, Expected Return on Plan Assets, and Amortization of Net Losses or Gains, and then subtract the Unfunded portion of the Pension Obligation when moving from Implied Enterprise Value to Implied Equity Value. Some companies embed these items within Operating Expenses on the Income Statement, so you may have to review the filings to calculate EBIT properly. If company contributions into the pension plan are tax-deductible (varies by country), you have to multiply the Unfunded Pension by (1 – Tax Rate) as well.

Question 32

Should you ever include items such as asset sales, impairments, or acquisitions in FCF?

Answer 32

For the most part, no. You certainly shouldn’t make speculative projections for these items – they are all non-recurring. If a company has announced plans to sell an asset, make an acquisition, or record a write-down in the near future, then you might factor it into FCF for that year. And if it’s an acquisition or divestiture, you’ll have to adjust FCF to reflect the cash spent or received, and you’ll have to change the company’s cash flow after the deal takes place.

Question 33

What does the Cost of Equity mean Intuitively?

Answer 33

It tells you the average percentage a company’s stock “should” return each year, over the very long term, factoring in both stock-price appreciation and dividends. In a valuation, it represents the percentage an Equity investor might earn each year (averaged over decades). To a company, the Cost of Equity represents the cost of funding its operations by issuing additional shares to investors. The company “pays for” Equity via potential Dividends (a real cash expense) and also by diluting existing investors (thereby giving up stock-price appreciation potential).

Question 34

What does WACC mean intuitively?

Answer 34

WACC is similar to Cost of Equity, but it’s the expected annual return if you invest proportionately in all parts of the company’s capital structure – Debt, Equity, Preferred Stock, and anything else it has. To a company, WACC represents the cost of funding its operations by using all its sources of capital and keeping its capital structure percentages the same over time. Investors might invest in a company if their expected IRR exceeds WACC, and a company might decide to fund a new project, acquisition, or expansion if its expected IRR exceeds WACC.

Question 35

How do you calculate Cost of Equity?

Answer 35

Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta The Risk-Free Rate represents what you would earn on “risk-free” government bonds denominated in the same currency as the company’s cash flows. You usually use 10-year or 20-year bonds to match the explicit forecast period of the DCF. Levered Beta represents how volatile this stock is relative to the market as a whole, factoring in both intrinsic business risk and risk from leverage. And the Equity Risk Premium represents how much the stock market in the company’s country will return above the “risk-free” government bond in the long term. Stocks are riskier and have higher potential returns than government bonds, so you take the rate of return on those government bonds, add the extra returns you could get from the stock market, and then adjust for this company’s specific risk and potential returns.

Question 36

If a company operates in the EU, U.S., and U.K., what should you use for its Risk-Free Rate?

Answer 36

You should use the rate on the government bonds denominated in the currency of the company’s cash flows. So, if the company reports its financials in USD, you might use the 10-year U.S. Treasury Rate; if it reports them in EUR or GBP, you might use the rate on 10-year bonds issued by the European Central Bank or the Bank of England.

Question 37

What should you use for the Risk-Free Rate if government bonds in the country are NOT risk-free (e.g. Greece)?

Answer 37

One option is to take the Risk-Free Rate in a country that is “risk-free,” like the U.S. or U.K., and then add a default spread based on your country’s credit rating. For example, you might start with a rate of 2.5% for 10-year U.S. Treasuries and then add a spread of 11.2% for Greece based on its current credit rating. That rate of 13.7% represents how yields are much higher in Greece due to the significant chance of government default.

Question 38

How do you calculate the Equity Risk Premium?

Answer 38

Stock-market returns differ based on the period and whether you use an arithmetic mean, a geometric mean, or other approaches, so there’s no universal method. Many firms use a publication called “Ibbotson’s” that publishes Equity Risk Premium data for companies of different sizes in different industries each year; some academic sources also track and report this data. You could also take the historical data for the U.S. stock market and add a premium based on the default spread of your country/market. For example, if the historical U.S. premium is 7%, you might add 3% to it if your country’s credit rating is Ba2, and that rating corresponds to a 3% spread. Finally, some groups use a “standard number” for each market, such as 5-6% in developed countries.

Question 39

How do you calculate the Equity Risk Premium for a multinational company that operates in many different geographies?

Answer 39

You might take the percentage revenue earned in each country, multiply it by the ERP in that market, and then add up everything to get the weighted average ERP. To calculate the ERP in each market, you might use one of the methods described in the previous question. The “Historical U.S. stock market returns + default spread” approach is common here.

Question 40

What does Beta mean intuitively?

Answer 40

Levered Beta tells you how volatile a company’s stock price is relative to the stock market as a whole, factoring in both intrinsic business risk and risk from leverage (i.e., Debt). If Beta is 1.0, when the market goes up 10%, this company’s stock price also goes up by 10%. If Beta is 2.0, when the market goes up 10%, this company’s stock price goes up by 20%. Unlevered Beta excludes the risk from leverage and reflects only the intrinsic business risk, so it’s always less than or equal to Levered Beta.

Question 41

Could Beta ever be negative?

Answer 41

Yes, it’s possible. The company’s stock price must move in the opposite direction of the entire market for Beta to be negative. Gold is commonly cited as an Asset that has a negative Beta because it often performs better when the stock market declines, and it acts as a “hedge” against disastrous macroeconomic events. However, negative Betas for companies are quite rare and usually revert to positive figures, even if they’re negative for short periods.

Question 42

Why do you have to un-lever and re-lever Beta when calculating the Cost of Equity?

Answer 42

You don’t “have to” un-lever and re-lever Beta: You could just use the company’s historical Beta, i.e., its own Levered Beta, and skip this step. But in a valuation, you’re estimating the company’s Implied Value – what it should be worth. The historical Beta corresponds more closely to the company’s Current Value – what the market says it’s worth today. By un-levering Beta for each comparable company, you isolate each company’s inherent business risk. Each company might have a different capital structure, so it’s important to remove the risk from leverage and isolate just the inherent business risk. You then take the median Unlevered Beta from these companies and re-lever it based on the capital structure (targeted or actual) of the company you’re valuing. You do this because there will always be business risk and risk from leverage, so you need to reflect both for the company you’re valuing. You can think of the result – Re-Levered Beta – as: “What the volatility of this company’s stock price, relative to the market as a whole, should be, based on the median business risk of its peer companies and this company’s capital structure.”

Question 43

What are the formulas for un-levering and re-levering Beta, and what do they mean?

Answer 43

Assuming the company has only Equity and Debt: Unlevered Beta = Levered Beta / (1 + Debt/Equity Ratio * (1 - Tax Rate)) Levered Beta = Unlevered Beta * (1 + Debt/Equity Ratio * (1 - Tax Rate)) If the company has Preferred Stock, you add another term for the Preferred / Equity Ratio. You use a “1 +” in front of Debt / Equity Ratio * (1 – Tax Rate) to ensure that Unlevered Beta is always less than or equal to Levered Beta. And you multiply the Debt / Equity Ratio by (1 – Tax Rate) because the tax-deductibility of interest reduces the risk of Debt. The formulas reduce Levered Beta to represent the removal of risk from leverage, but they increase Unlevered Beta to represent the addition of risk from leverage.

Question 44

In those formulas, you’re not factoring in the interest rate on Debt. Isn’t that wrong? More expensive Debt should be riskier.

Answer 44

Yes, this is one drawback. However: 1. The Debt / Equity ratio is a proxy for interest rates on Debt because companies with high Debt / Equity ratios tend to pay higher interest rates as well.
2. The risk isn’t directly proportional to interest rates. Higher interest on Debt will result in lower coverage ratios (EBITDA / Interest) and, therefore, more risk, but it’s not as simple as saying, “Interest is now 4% rather than 1% – risk is 4x higher.” An interest rate that’s 4x higher might barely change a large company’s financial profile, but it might make a much bigger difference for a small company.

Question 45

Do you still un-lever and re-lever Beta even when you’re using Unlevered FCF?

Answer 45

Yes. Un-levering and re-levering Beta has NOTHING to do with Unlevered vs. Levered FCF. A company’s capital structure affects both the Cost of Equity and WACC, so you un-lever and re-lever Beta regardless of the type of Free Cash Flow you’re using.

Question 46

What are some different ways to calculate Beta in the Cost of Equity calculation?

Answer 46

Some people argue that you should use the Predicted Beta instead of the Historical Beta because the Cost of Equity relates to expected future returns. If you do use historical data, you could use the company’s Historical Beta or the re-levered Beta based on comparable companies. And if you re-lever Beta, you could do it based on the company’s current capital structure, its targeted or “optimal” structure, or the capital structure of the comparable companies. Most of these methods produce similar results, and you always use a range of values when calculating Cost of Equity and WACC.

Question 47

How would you estimate the Cost of Equity for a U.S.-based technology company?

Answer 47

This question tests your ability to make a guesstimate based on common sense and your knowledge of current market rates. You might say, “The Risk-Free Rate is around 1.5% for 10-year U.S. Treasuries. A tech company like Salesforce is more volatile than the market as a whole, with a Beta of around 1.5. So, if you assume an Equity Risk Premium of 8%, Cost of Equity might be around 13.5%.” The numbers will change based on market conditions, but that’s the idea.

Question 48

How do you calculate WACC, and what makes it tricky?

Answer 48

The formula for WACC is simple: WACC = Cost of Equity * % Equity + Cost of Debt * (1 – Tax Rate) * % Debt + Cost of Preferred Stock * % Preferred Stock But it’s tricky to calculate because of the ambiguity with many of these items: 1. Cost of Debt: Do you use the weighted average coupon rate on the company’s bonds? Or the Yield to Maturity (YTM)? Or the YTM of Debt from comparable companies?

2. Percentages of Debt, Equity, and Preferred Stock: Do you use the company’s current capital structure, “optimal” structure, or targeted structure? Or do you use the median percentages from the comparable public companies?
3. Cost of Equity: There are different ways to calculate Beta, and no one agrees on the Equity Risk Premium.

Question 49

WACC reflects the company’s entire capital structure, so why do you pair it with Unlevered FCF? It’s not capital structure-neutral!

Answer 49

Think of Unlevered FCF as “Free Cash Flow to Firm,” or FCFF, instead. And think of this relationship as: “Unlevered FCF, or FCFF, is available to ALL investors, and WACC represents ALL investors. Therefore, you pair WACC with Unlevered FCF.” No Discount Rate can be “capital structure-neutral” since each part of a company’s capital structure affects the other parts. “Capital-structure neutrality” is a property of Free Cash Flow, not the Discount Rate.

Question 50

Should you use the company’s current capital structure or optimal structure to calculate WACC?

Answer 50

A company’s “optimal” capital structure is the one that minimizes its WACC. But there’s no way to calculate it because you can’t tell in advance how the Costs of Equity, Debt, and Preferred will change as the capital structure changes. So, in practice, you’ll often use the median capital structure percentages from the comparable public companies as a proxy for the “optimal” capital structure. It’s the same as the logic for un-levering and re-levering Beta: You want to capture what this company’s capital structure should be, not what it is right now. It’s better to use this expected capital structure because the company’s Implied Value in a DCF is based on its expected, future cash flows.

Question 51

Should you use Total Debt or Net Debt to determine the capital structure percentages in the WACC calculation?

Answer 51

Some textbooks claim that you should use Equity Value + Debt + Preferred Stock – Cash, rather than Equity Value + Debt + Preferred Stock, for the denominator of the capital structure percentages. However, we disagree with this approach for several reasons: 1) Cash Does Not “Offset” Debt – For example, many forms of Debt do not allow for early repayment or penalize the company for early repayment. So, a high Cash balance doesn’t necessarily reduce the risk of Debt on a 1:1 basis.
2) You May Get Nonsensical Results with High Cash Balances – For example, if the company’s Cash exceeds its Debt, Debt as a Percentage of Total Capital will be far too low. This will artificially inflate the Discount Rate since Equity is more expensive than Debt for most companies.

Question 52

Why is Equity more expense than Debt?

Answer 52

Because it offers higher risk and higher potential returns. Expected stock market returns (plus dividends) exceed the interest rates on Debt in most cases, which already makes the Cost of Equity higher. But the interest on Debt is also tax-deductible, which further reduces its cost. In developed markets like the U.S., the average annualized stock market return is around 10-11%. So, a company with a Beta of 1.0 will have a Cost of Equity in that range. For the Cost of Debt to be higher, the Pre-Tax Cost would have to be ~17-18% at a 40% tax rate. Hardly any Debt has interest rates that high.

Question 53

How does the Cost of Preferred Stock compare with the Costs of Debt and Equity?

Answer 53

Preferred Stock tends to be more expensive than Debt but less expensive than Equity: It offers higher risk and potential returns than Debt, but lower risk and potential returns than Equity. That’s because the coupon rates on Preferred Stock tend to be higher than the rates on Debt, and Preferred Dividends are not tax-deductible. But these rates are still lower than expected stock market returns. The risk is also lower since Preferred Stock investors have a higher claim on the company’s Assets than Equity investors.

Question 54

How do you determine the Cost of Debt and Cost of Preferred Stock in the WACC Calculation and what do they mean?

Answer 54

These Costs represent the rates a company would pay if it issued additional Debt or additional Preferred Stock. There is no way to observe these rates directly, but you can estimate them. For example, you could calculate the weighted average coupon rate on the company’s existing Debt or Preferred Stock or the median coupon rate on the outstanding issuances of comparable public companies. You could also use the Yield to Maturity (YTM), which reflects the market prices of the bonds (a bond with a coupon rate of 5% that’s trading at a discount to par value will have a YTM higher than 5%). Finally, you could also take the Risk-Free Rate and add a default spread based on the company’s expected credit rating if it issues more Debt or Preferred Stock. If you think its credit rating will fall from BB+ to BB after issuing Debt, you’d look up the average spread for BB-rated companies and add it to the Risk-Free Rate.

Question 55

How do convertible bonds factor into the WACC calculation?

Answer 55

If the company’s current share price exceeds the conversion price of the bonds, you count the bonds as Equity and factor them in by using a higher diluted share count, resulting in a higher Equity Value for the company and a greater Equity weighting in the WACC formula. But if the bonds are not currently convertible, you count them as Debt and use the coupon rate (or YTM, or another method) to calculate their Cost. Convertible bonds offer lower coupon rates than standard corporate bonds, so you should use the rate on equivalent, non-convertible bonds. Convertible bonds almost always reduce WACC when they count as Debt since the Cost of Debt is lower than the Cost of Equity.

Question 56

How do the Cost of Equity, Cost of Debt, and WACC change as a company uses more Debt?

Answer 56

The Cost of Equity and Cost of Debt always increase because more Debt increases the risk of bankruptcy, which affects all investors. As a company goes from no Debt to some Debt, WACC decreases at first because Debt is cheaper than Equity, but it starts increasing at higher levels of Debt as the risk of bankruptcy starts to outweigh the lower Cost of Debt. However, the exact impact depends on where you are on that curve. If the company already has a very high level of Debt, WACC is likely to increase with more Debt; at lower levels of Debt, WACC is more likely to decrease with more Debt.

Question 57

How do those figures change as the company uses less Debt?

Answer 57

The Cost of Equity and Cost of Debt decrease for the reasons stated above: Less Debt means a lower risk of bankruptcy and, therefore, less risk for all investors. WACC could go either way depending on where you are on the curve. If the company already has a very high level of Debt, WACC will likely decrease with less Debt; if its Debt level is much lower, WACC will likely increase with less Debt.

Question 58

If a company previously used 20% Debt and 80% Equity, but it just paid off all its Debt, how does that affect its WACC.

Answer 58

It depends on how you’re calculating WACC. If you’re using the company’s current capital structure, WACC will most likely increase because 20% Debt is a fairly low level. At that low level, the benefits of Debt still outweigh its risks, so less Debt will increase WACC. But if you’re using the targeted, optimal, or median capital structure from the comparable companies, this change won’t affect WACC because you’re not using the company’s current capital structure at all.

Question 59

Should you ever use different Discount Rates for different years in a DCF?

Answer 59

Yes, sometimes it makes sense to use different Discount Rates. For example, if a company is growing quickly right now, but is expected to grow more slowly in the future, you might decrease the Discount Rate each year until the company reaches maturity. So, if the company’s current WACC is between 11% and 13%, and WACC for mature companies in the industry is between 8% and 9%, you might start it at 12% and then reduce it by 0.4% in each year of the explicit forecast period until it reaches 8.4% by the end. It makes less sense to do this if the company is already mature and is not expected to change much over time.

Question 60

What is the difference between the explicit forecast period and the Terminal Period in a DCF?

Answer 60

The company’s Free Cash Flow Growth Rate, and possibly its Discount Rate, change over time in the explicit forecast period since the company is still growing and changing. But in the Terminal Period, you assume that the company remains in a “steady state” forever: Its Free Cash Flow grows at the same rate each year, and its Discount Rate remains the same.

Question 61

What’s the intuition behind the Gordon Growth formula for Terminal Value?

Answer 61

The typical formula is: Terminal Value = Final Year FCF * (1 + Terminal FCF Growth Rate) / (Discount Rate – Terminal FCF Growth Rate) But it’s more intuitive to think of it as: Terminal Value = FCF in Year 1 of Terminal Period / (Discount Rate – Terminal FCF Growth Rate) A company is worth less if the Discount Rate is higher and worth more if the Terminal FCF Growth Rate is higher. For example, let’s say the company’s FCF is not growing, and its Discount Rate is 10%. It has $100 in FCF in the first year of the Terminal Period. You would be willing to pay $100 / 10%, or $1,000, so the Terminal Value is $1,000. If the Discount Rate falls to 5%, now you’d pay $100 / 5%, or $2,000. If it increases to 20%, you’d pay $100 / 20%, or $500. The company is worth more when you have worse investment options elsewhere, and worth less when you have better investment options elsewhere. Now let’s say the company’s FCF is growing. If it grows by 3% per year, you’d be willing to pay $100 / (10% – 3%), or ~$1,429 for it. But if its FCF growth rate increases to 5% per year, you’d be willing to pay $100 / (10% – 5%), or $2,000, for it. Higher growth lets you achieve the same targeted return even when you pay more.

Question 62

If you use the Multiples Method to calculate Terminal Value, do you use the multiples from the Public Comps or Precedent Transactions?

Answer 62

Neither one – you just use them as starting points in the analysis, and then you adjust once you’ve calculated the Terminal FCF Growth Rates implied by the selected multiples. It’s better to start with the multiples from the Public Comps, ideally the ones from 1-2 years into the future, because you don’t want to reflect the control premium inherent in Precedent Transactions, at least not if you’re completing a standalone valuation of the company. Then, if the multiples imply a reasonable Terminal FCF Growth Rate, you might stick with your initial guess; if not, adjust it up or down as necessary.

Question 63

How do you pick the Terminal Growth Rate when you calculate the Terminal Value using the Gordon Growth Method?

Answer 63

This growth rate should be below the country’s long-term GDP growth rate and in-line with other macroeconomic variables like the rate of inflation. For example, if you’re in a developed country where the expected long-term GDP growth rate is 3.0%, you might use numbers ranging from 1.5% to 2.5% for the range of Terminal Growth Rates. You should NOT pick a rate above the country’s long-term GDP growth rate because the company will become bigger than the economy as a whole after a certain point! You can then check your work by calculating the Terminal Multiples implied by these growth rates.

Question 64

Why do you need to discount the Terminal Value back to its Present Value?

Answer 64

Because the Terminal Value represents the Present Value of the company’s cash flows from the very end of the explicit forecast period into perpetuity. In other words, it represents the company’s value IN a future period AT a point in the future. Valuation tells you what a company is worth TODAY, so any “future value” must always be discounted back to its Present Value. If you did not discount the Terminal Value, you’d greatly overstate the company’s Implied Value because you’d be acting as if its Year 6, 11, or 16 cash flows arrived next year.

Question 65

When you discount the Terminal Value, why do you use the number of the last year in the forecast period for the discount period (for example, 10 for a 10-year forecast)? Shouldn’t you use 11 since Terminal Value represents the Present Value of cash flows starting in Year 11?

Answer 65

No. The Terminal Value does represent the Present Value of cash flows starting in Year 11, but it’s the Present Value as of the very end of Year 10. You would use 11 for the discount period only if your explicit forecast period went to Year 11 and the Terminal Period started in Year 12.

Question 66

What do you do after summing the PV of Terminal Value and the PV of Free Cash Flows?

Answer 66

If you’re building a Levered DCF analysis, you’re almost done because this summation gives you the company’s Implied Equity Value. The last step is to divide the company’s Implied Equity Value by its diluted share count to get its Implied Share Price (if the company is public). In an Unlevered DCF, the PV of Terminal Value + PV of Free Cash Flows equals the company’s Implied Enterprise Value, so you have to “back into” the Implied Equity Value and then calculate its Implied Share Price. You do this by adding non-core-business Assets (Cash, Investments, etc.) and subtracting Liability and Equity items that represent other investor groups (Debt, Preferred Stock, Noncontrolling Interests, etc.). Then, you divide by the company’s diluted share count to get its Implied Share Price.

Question 67

The diluted share count includes dilution from the company’s in-the-money options. But what about its out-of-the-money options? Shouldn’t you account for them in a DCF?

Answer 67

In theory, yes. Some professors, such as Damodaran, use Black-Scholes to value these out-of-the-money options and then subtract them to determine the company’s Implied Equity Value. In practice, banks rarely include out-of-the-money options in a DCF. These options tend to make a small impact on most companies, and options valuation is tricky and requires inputs that you may or may not have. So, it is usually not worth the time and effort.

Question 68

How can you check whether or not your Terminal Value estimate is reasonable?

Answer 68

It’s an iterative process: You start by entering a range of assumptions for the Terminal Multiple or Terminal FCF Growth Rate, and then you cross-check your assumptions by calculating the Growth Rates or Multiples they imply. If it seems wrong, then you adjust the range of Terminal Multiples or Terminal FCF Growth Rates until you get more reasonable results. Example: You start by picking 10x EV / EBITDA for the Terminal Multiple. At a Discount Rate of 12%, this multiple implies a Terminal FCF Growth Rate of 5%, which is too high. So, you reduce it to 6x EV / EBITDA, but now the Implied Terminal FCF Growth Rate drops to 1%, which is too low. So, you guess 8x EV / EBITDA, which implies a Terminal FCF Growth Rate of 2.3%. That is more reasonable since it’s below the expected long-term GDP growth rate, but it’s also slightly above the inflation rate. This 8x figure might be your “Baseline Terminal Multiple,” so you would start there and go slightly above and below it in the sensitivity tables.

Question 69

What’s one problem with using EV/EBITDA multiples to calculate Terminal Value?

Answer 69

The biggest issue is that EBITDA ignores CapEx. Two companies with similar EV / EBITDA multiples might have very different Free Cash Flow and FCF growth figures. As a result, their Implied Values might differ significantly even if they have similar EV / EBITDA multiples. You may get better results by using EV / EBIT, EV / NOPAT, or EV / Unlevered FCF, but those multiples create other issues, such as less comparability across peer companies. This problem is one reason why the Gordon Growth Method is still the “real” way to calculate Terminal Value.

Question 70

Would it ever make sense to use a negative Terminal FCF Growth Rate?

Answer 70

Yes. For example, if you’re valuing a biotech or pharmaceutical company and the patent on its key drug expires within the explicit forecast period, you might assume that the company’s cash flows eventually decline to $0. A negative Terminal FCF Growth Rate represents your expectation that the company will stop generating cash flow eventually. It doesn’t make the company “worthless”; it just means that the company will be worth less.

Question 71

How can you determine which assumptions to analyze in sensitivity tables for a DCF?

Answer 71

The same assumptions make a big impact in any DCF: The Discount Rate, the Terminal FCF Growth Rate or Terminal Multiple, and the revenue growth and margin figures. It doesn’t make sense to sensitize much else – the assumptions for CapEx and Working Capital, for example, tend to make a small difference. There may also be industry-specific assumptions that are worth sensitizing, such as the patent expiration dates for drugs in the biotech/pharmaceutical industry.

Question 72

Which assumptions make the biggest impact on a DCF?

Answer 72

The Discount Rate and Terminal Value make the biggest impact on the DCF. That’s because the Discount Rate affects the PV of everything and because the PV of the Terminal Value often represents 50%+ of the company’s Implied Value. The assumptions for revenue growth and operating margins also make a significant impact, but less than the ones above. Other items, such as CapEx, Working Capital, and non-cash adjustments, make a smaller impact.

Question 73

Should Cost of Equity and WACC be higher for a $5 billion or $500 million Equity Value company?

Answer 73

Assuming that both companies have the same capital structure percentages, Cost of Equity and WACC should both be higher for the $500 million company. All else being equal, smaller companies tend to offer higher potential returns and higher risk than larger companies, which explains why Cost of Equity will be higher. Since smaller companies have a higher chance of defaulting on their Debt, their Cost of Debt (and Preferred) also tends to be higher. And since all the Costs tend to be higher for smaller companies, WACC must be higher, assuming the same capital structure percentages.

Question 74

Would increasing the revenue growth from 9% to 10% or increasing the Discount Rate from 9% to 10% make a bigger impact on a DCF?

Answer 74

The Discount Rate increase will make a bigger impact. Increasing revenue growth from 9% to 10% will barely impact FCF and Terminal Value, but the Discount Rate will affect the Present Value of everything, and 9% vs. 10% is a significant difference.

Question 75

Would it make a bigger impact to increase revenue growth from 9% to 20%, or to increase the Discount Rate from 9% to 10%?

Answer 75

It’s harder to tell here. Doubling a company’s revenue growth could make a bigger impact than changing the Discount Rate by 1%, but when the changes are this different, you’d have to run the numbers to tell. These operational changes make a bigger impact in longer projection periods than they do in shorter ones, so you would see more of a difference in a 10-year DCF than a 5-year one.

Question 76

Two companies produce identical total Free Cash Flows over a 10-year period, but Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining 9 years. Company B generates the same amount of Free Cash Flow in every year. Which company will have the higher Implied Value in a DCF?

Answer 76

This is a trick question because it depends on what you count toward the Implied Value. If it’s just this series of cash flows, Company A will have the higher Implied Value because of the time value of money: The cash flows arrive earlier, so they’re worth more. However, Company B will almost certainly have a much higher Terminal Value because it has a much higher FCF in Year 10. So, if you count the PV of Terminal Value in the analysis, it’s a good bet that Company B will have the higher Implied Value.

Question 77

How does the tax rate affect the Cost of Equity, Cost of Debt, WACC, and the Implied Value from a DCF?

Answer 77

The tax rate affects the Cost of Equity, Cost of Debt, and WACC only if the company has Debt. If the company does not have Debt, or its targeted/optimal capital structure does not include Debt, the tax rate doesn’t matter because there’s no tax benefit to interest paid on Debt. If the company has some Debt, a higher tax rate will reduce the Cost of Equity, Cost of Debt, and WACC. It’s easy to see why it reduces the Cost of Debt: Since you multiply by (1 – Tax Rate), a higher rate always reduces the after-tax cost. But it also reduces the Cost of Equity for the same reason: With a greater tax benefit, Debt is less risky even to Equity investors. And if both of these are lower, WACC will also be lower. However, the Implied Value from a DCF will also be lower because the higher tax rate reduces FCF and the company’s Terminal Value. Those changes outweigh a lower WACC. The opposite happens with a lower tax rate: The Cost of Equity, Cost of Debt, and WACC are all higher, and the Implied Value is also higher.

Question 78

Can you walk me through how you use Public Comps and Precedent Transactions in a Valuation?

Answer 78

First, you select the companies and transactions based on criteria such as industry, size, and geography (and time for the transactions). Then, you determine the appropriate metrics and multiples for each set – for example, revenue, revenue growth, EBITDA, EBITDA margins, and revenue and EBITDA multiples – and you calculate them for all the companies and transactions. Next, you calculate the minimum, 25th percentile, median, 75th percentile, and maximum for each valuation multiple in the set. Finally, you apply these numbers to the financial metrics of the company you’re analyzing to estimate its Implied Value. For example, if the company you’re valuing has $100 million in LTM EBITDA, and the median LTM EV / EBITDA multiple in a set of comparable companies is 7x, then the company’s implied Enterprise Value is $700 million. You then calculate its Implied Value for all the other multiples to get a range of possible values.

Question 79

Why is it important to select Public Comps and Precedent Transactions that are similar?

Answer 79

Because the comparable companies and transactions should have similar Discount Rates and Free Cash Flow figures. Remember that a company’s valuation multiples depend on its Free Cash Flow, Discount Rate, and Expected FCF Growth Rate. If the companies in your set all have similar Discount Rates and Free Cash Flows, it’s easier to conclude that one company trades at higher multiples because its expected growth rate is higher. If the companies do not have similar Discount Rates and Free Cash Flows, it’s harder to draw meaningful conclusions.

Question 80

How do you select Comparable Companies and Precedent Transactions?

Answer 80

You screen based on geography, industry, and size, and also time for Precedent Transactions.

Question 81

Are there any screens you should AVOID when selecting Comparable Companies and Precedent Transactions?

Answer 81

You should avoid screening by both financial metrics and Equity Value or Enterprise Value. For example, you should NOT use this screen: “Companies with revenue below $1 billion and Enterprise Values above $2 billion.” If you use that screen, you’re artificially constraining the multiples because EV / Revenue must be above 2x for every company in the set.

Question 82

Public Comps and Precedent Transactions seem similar. What are the main differences?

Answer 82

The idea is similar – you use Current valuation multiples from similar companies or deals to value a company – but the execution is different. Here are the differences for Precedent Transactions: • Screening Criteria: In addition to industry, size, and geography, you also use time because you only want transactions from the past few years. You might also use Transaction Size, and you might use broader screening criteria in general.
• Metrics and Multiples: You focus on historical metrics and multiples, especially LTM revenue and EBITDA as of the announcement date.
• Calculations: All the multiples are based on the purchase price as of the announcement date of the deal.
• Output: The multiples produced tend to be higher than the multiples from Public Comps because of the control premium. But the multiples also tend to span wider ranges because deals can be done for many different reasons.

Question 83

Can you walk me through the process of finding market and financial information for the Public Comps?

Answer 83

You start by finding each company’s most recent annual and interim (quarterly or half-year) filings. You calculate its diluted share count and Current Equity Value and Current Enterprise Value based on the information there and its most recent Balance Sheet. Then, you calculate its Last Twelve Months (LTM) financial metrics by taking the most recent annual results, adding the results from the most recent partial period, and subtracting the results from the same partial period the last year. For the projected figures, you look in equity research or find consensus figures on Bloomberg. And then you calculate all the multiples by dividing Current Equity Value or Current Enterprise Value by the appropriate metric.

Question 84

Can you walk me through the process of finding market and financial information for the Precedent Transactions?

Answer 84

You find the acquired company’s filings from just before the deal was announced, and you calculate the LTM financial metrics using those. To calculate the company’s Transaction Equity Value and Enterprise Value, you use the purchase price the acquirer paid, and you move from Equity Value to Enterprise Value in the same way you usually do, using the company’s most recent Balance Sheet as of the announcement date. You calculate all the valuation multiples in the same way, using Transaction Equity Value or Transaction Enterprise Value as appropriate.

Question 85

How do you decide which metrics and multiples to use in these methodologies?

Answer 85

You usually look at a sales-based metric and its corresponding multiple and 1-2 profitability-based metrics and multiples. For example, you might use Revenue, EBITDA, and Net Income, and the corresponding multiples: EV / Revenue, EV / EBITDA, and P / E. You do this because you want to value a company in relation to how much it sells and to how much it keeps of those sales. Sometimes, you’ll drop the sales-based multiples and focus on profitability or cash flow-based ones (EBIT, EBITDA, Net Income, Free Cash Flow, etc.).

Question 86

Why do you look at BOTH historical and projected metrics and multiples in these methodologies?

Answer 86

Historical metrics are useful because they’re based on what actually happened, but they can also be deceptive if there were non-recurring items or if the company made acquisitions or divestitures. Projected metrics are useful because they assume the company will operate in a “steady state” without acquisitions, divestitures, or non-recurring items, but they’re also less reliable because they’re based on predictions of the future.

Question 87

When you calculate forward multiples for the comparable companies, should you use each company’s Current Equity Value or Current Enterprise Value, or should you project them to get the Year 1 or Year 2 values?

Answer 87

No, you always use the Current Equity Value or Current Enterprise Value. NEVER “project” either one. A company’s share price, and, therefore, both of these metrics, is based on past performance and future expectations. So, to “project” these metrics, you’d have to jump into the future and see what future expectations are at that point, which doesn’t make sense.

Question 88

What should you do if some companies in your set of Public Comps have fiscal years that end on June 30th and others have fiscal years that end on December 31st?

Answer 88

You have to “calendarize” by adjusting the companies’ fiscal years so that they match up. For example, to make everything match a December 31st year-end date, you take each company with a June 30th fiscal-year end and do the following: • Start with the company’s full June 30th fiscal-year results. • Add the June 30th – December 31st results from this year. • Subtract the June 30th – December 31st results from the previous year. Normally, you calendarize to match the fiscal year of the company you’re valuing. But you might pick another date if, for example, all the comparable companies have December 31st fiscal years but your company’s ends on June 30th.

Question 89

How do you interpret the Public Comps? What does it mean if the median multiples are above or below the ones of the company you’re valuing?

Answer 89

The interpretation depends on how the growth rates and margins of your company compare to those of the comparable companies. Public Comps are most meaningful when the growth rates and margins are similar, but the multiples are different. This could mean that the company you’re valuing is mispriced and that there’s an opportunity to invest and make money. For example, all the companies are growing their revenues at 10-15% and their EBITDAs at 15-20%, and they all have EBITDA margins of 10-15%. Your company also has multiples in these ranges. However, your company trades at EV / EBITDA multiples of 6x to 8x, while the comparable companies all trade at multiples of 10x to 12x. That could indicate that your company is undervalued since its multiples are lower, but its growth rates, margins, industry, and size are all comparable. If the growth rates and margins are very different, it’s harder to draw conclusions.

Question 90

Is it valid to include both announced and closed deals in your set of Precedent Transactions?

Answer 90

Yes, because Precedent Transactions reflect overall market activity. Even if a deal hasn’t closed yet, the simple announcement of the deal reflects what one company believes another is worth. Note that you base all the metrics and multiples on the financial information as of the announcement dates.

Question 91

Why do Precedent Transactions often result in more “random” data than Public Comps?

Answer 91

The problem is that the circumstances surrounding each deal might be very different. For example, one company might have sold itself because it was distressed and about to enter bankruptcy. But another company might have sold itself because the acquirer desperately needed it and was willing to pay a high price. Some deals are competitive and include multiple acquirers bidding against each other, while others are more targeted and do not involve competitive bidding. All these factors mean that the multiples tend to vary widely, more so than the multiples for Public Comps.

Question 92

How do you factor in earn-outs and expected synergies in Precedent Transactions?

Answer 92

You generally don’t factor in expected synergies because they’re so speculative. If you do include them, you might increase the sellers’ projected revenue or EBITDA figures so that the valuation multiples end up being lower. Opinions differ on earn-outs, but you could assume that they have a 50% chance of being paid out, multiply the earn-out amounts by 50%, and add them to the purchase prices. Other people ignore earn-outs or add the full earn-out amounts to the purchase prices.

Question 93

Are there any rules about filtering out deals for less than 100% of companies or about stock vs. cash deals in Precedent Transactions?

Answer 93

Ideally, your set of Precedent Transactions will include only 100% acquisition deals. However, you may need to go beyond that and also include majority-stake deals (ones where the acquirer buys more than 50% but less than 100% of the seller). You can include those because the dynamics are similar, but you should not include minority-stake deals because acquiring 10% or 20% of a company is quite different. Stock vs. cash consideration affects buyers’ willingness to pay in M&A deals, but you typically include all deals regardless of the form of consideration. You may note whether each deal was cash, stock, or a mix of both.

Question 94

If there’s a Precedent Transaction where the buyer acquired 80% of the seller, how do you calculate the valuation multiples?

Answer 94

The multiples are ALWAYS based on 100% of the seller’s value. So, if the acquirer purchased 80% of the seller for $500 million, the Purchase Equity Value would be $500 million / 80% = $625 million. And then you would calculate the Purchase Enterprise Value based on that figure plus the usual adjustments. You would then calculate the valuation multiples based on those figures and the financial stats for 100% of the seller.

Question 95

Why do you use median multiples rather than average multipliers or other percentiles?

Answer 95

Median multiples are better than average multiples because of outliers. If there are 5 companies in your set, and the multiples are 8x, 10x, 9x, 8x, and 25x, you don’t want the 25x multiple to push up the average when it’s clearly an outlier. However, there’s no “rule” that you have to use the median rather than other percentiles, so you could make an argument for using the 25th percentile or 75th percentile. For example, you could argue that your company’s growth rates and margins are in-line with those of companies in the 75th percentile of your set and that the 75th percentile multiples are, therefore, most applicable to your company.

Question 96

What is a Liquidation Valuation, and when is it useful and not so useful?

Answer 96

In a Liquidation Valuation, you value a company by determining the fair market values of all of its Assets, adding them up, and subtracting the fair market values of all its Liabilities. It gives you the company’s Implied Equity Value because you’re valuing all the company’s Assets rather than just its core-business Assets. This methodology is useful for distressed companies because it tells you how much they might be worth if they have to liquidate and shut down. It’s less useful for healthy, growing companies because it tends to undervalue them greatly. A growing company is worth a lot more than what’s on its Balance Sheet because of its future growth potential.

Question 97

How does a Dividend Discount Model (DDM) differ from a DCF?

Answer 97

In a DDM, rather than projecting Free Cash Flow, you project the company’s Dividends, usually based on a percentage of Net Income. You then discount the Dividends to their Present Value using the Cost of Equity and add them up. To calculate the Terminal Value, you use an Equity Value-based multiple such as P / E (or the Gordon Growth Method), and then you discount it to its Present Value using the Cost of Equity. You calculate the company’s Implied Equity Value at the end rather than its Implied Enterprise Value, and you divide it by the diluted share count to get the company’s Implied Share Price. The DDM is essential in some industries, such as commercial banks and insurance, useful for other industries that pay regular dividends, such as REITs, utilities, and some MLPs, and not so useful for most others.

Question 98

Why might you use an M&A Premiums analysis to value a company?

Answer 98

The M&A Premiums analysis applies only to public companies because you look at acquisitions of similar public companies and calculate the “premium” each buyer paid for each seller. For example, if the seller’s share price was $12.00 before the deal, and the buyer paid $15.00 per share, that represents a 25% premium. You take the median for a set of transactions and then use that percentage to value your company. If the median premium is 20%, and your company’s share price is $10.00, it’s worth $12.00 per share. This analysis is useful when Precedent Transactions give nonsensical results, and you want to use something other than traditional multiples to value your company. For example, if the Precedent Transactions were all done at EV / EBITDA multiples between 6x and 8x, and your company is currently at trading at 10x EV / EBITDA, the results don’t make sense: A public company can’t sell for less than its current multiples. So, you could look at the M&A premiums instead. If the median premium is 25%, you might apply that to your company’s share price and say that a buyer might have to pay that much to do the deal.

Question 99

How do you build a Future Share Price Analysis?

Answer 99

You take the median historical multiple from the Public Comps, often the P / E multiple, and apply it to the future metric of the company you’re valuing (Net Income or EPS with the P / E multiple). You assume that in 1-2 years, the company will be trading at the median multiple the comparable companies are currently trading at. For example, if the median P / E is 15x, and the company’s Year 1 projected EPS is $1.00, you could say the company’s expected “future share price” is 15 * $1.00 = $15.00. Then, you discount this future share price to its Present Value by using a range of values for the company’s Cost of Equity. For Enterprise Value-based multiples, you back into the Implied Equity Value and Implied Share Price in future years and then discount that share price to its Present Value.

Question 100

What are the advantages and disadvantages of a Sum-of-the-Parts Valuation?

Answer 100

The Sum-of-the-Parts methodology, where you value each division of a company separately and add them up to determine the company’s Implied Value, works well for conglomerates like General Electric that have very different divisions. The divisions operate in such different industries that it would be meaningless to value the company as a whole – no other company would be truly comparable. But Sum of the Parts also takes far more time and effort to set up because you have to find comparable companies and transactions for each division, build a separate DCF for each division, and so on. Also, you may not have enough information to use it – companies sometimes don’t disclose EBIT or CapEx by division, and they may not disclose the corporate overhead expenses that you must factor in at the end of the analysis.

Question 101

How do you set up an LBO valuation, and when is it useful?

Answer 101

You set up the LBO valuation by creating a leveraged buyout model where a private equity firm acquires a company using Debt and Equity, holds it for several years, and then sells it for a certain multiple of EBITDA. Since most private equity firms target an internal rate of return (IRR) in a specific range, you work backward and determine the maximum purchase price the PE firm can pay to achieve a minimum IRR. You use the “Goal Seek” function in Excel to do this, and you solve for the purchase price based on constraints for the IRR, exit multiple, and Debt / Equity split. This methodology is useful for setting a floor on the company’s valuation – you’re constraining the price because of the IRR requirement. It’s also useful for estimating what a private equity firm, rather than a normal company, might be willing to pay for a company.