Valuation Methods

Question 1

What are the 3 major valuation methodologies?

Answer 1

Comparable Companies, Precedent Transactions and Discounted Cash Flow Analysis.

Question 2

Walk me through a three-way / discounted cash flow (DCF) model.

Answer 2

• A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value.
• First, you project out a company’s financials using assumptions for revenue growth, expenses and Working Capital; then you get down to Free Cash Flow for each year, which you then sum up and discount to a Net Present Value, based on your discount rate – usually the WACC.
• Once you have the present value of the Cash Flows, you determine the company’s Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then also discount that back to its Net Present Value using WACC.
• Finally, you add the two together to determine the company’s Enterprise Value.

Question 3

Walk me through how you get from Revenue to Free Cash Flow in the projections.

Answer 3

Start with Revenue.

Subtract COGS and Operating Expenses to get to Operating Income (EBIT).

Then, multiply by (1 – Tax Rate), add back Depreciation and other non‐cash charges, and subtract Capital Expenditures and the change in Working Capital.

This gets you to Unlevered Free Cash Flow since you went off EBIT rather than EBT.

Question 4

How do you calculate terminal value?

Answer 4

You can either apply an exit multiple to the company’s Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you can use the Gordon Growth method to estimate its value based on its growth rate into perpetuity.

To get the exit multiple, you’d look at companies in the same sector to derive an average.

Question 5

What is the Gordon Growth Model?

Answer 5

The Gordon Growth Model assumes a constant growth in a company’s dividend payments. It adds up the values of all of its expected future dividend payments and discounts them back to their present values to give terminal value.

Question 6

What are the limitations of a DCF model?

Answer 6

A DCF analysis is a method to evaluate the intrinsic value of a company, but it has several limitations:

1. It’s very sensitive to assumptions used to calculate the terminal value and the discount rate – and these assumptions are nearly impossible to accurately predict
2. The terminal value represents a disproportionately large amount of the value of the total company

Question 7

When would you not use a DCF in a Valuation?

Answer 7

You do not use a DCF if the company has unstable or unpredictable cash flows (tech or startup) or when debt and working capital serve a fundamentally different role.

For example, banks and financial institutions do not re‐invest debt and working capital is a huge part of their Balance Sheets – so you wouldn’t use a DCF for such companies.

Question 8

What’s the difference between levered and unlevered free cash flow?

Answer 8

Expenses. Levered cash flow is the amount of cash a company has after it has met all of its financial obligations.

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the cash flow is only available to equity investors (debt investors have already been “paid” with the interest payments).

Question 9

What’s the difference between WACC and cost of equity?

Answer 9

WACC is the minimum rate of return required on an investment for all capital providers, i.e., both debt and equity holders.

In contrast, the cost of equity is the required rate of return for equity shareholders only.

Question 10

How do you calculate WACC?

Answer 10

A company’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all sources.

The formula is: Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 – Tax Rate) + Cost of Preferred * (% Preferred).

In all cases, the percentages refer to how much of the company’s capital structure is taken up by each component.

Question 11

How do you calculate Cost of Equity?

Answer 11

• Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium
• The risk-free rate represents how much a 10-year or 20-year US Treasury should yield.
• Beta is calculated based on the “riskiness” of comparable companies.
• The equity risk premium is the % by which stocks are expected to out-perform “risk-less” assets. (Historically, ranges around 4-6%)
• Depending on how precise you want to be, you could also add in a size premium or an industry premium to account for how much a company is expected to outperform its peers according to its market cap or industry.

Question 12

How do you get to Beta in the Cost of Equity calculation?

Answer 12

You look up the Beta for each Comparable Company (usually on Bloomberg), un‐lever
each one, take the median of the set and then lever it based on your company’s capital
structure. Then you use this Levered Beta in the Cost of Equity calculation.

When you look up the Betas on Bloomberg (or from whatever source you’re using) they will be levered to reflect the debt already assumed by each company.

But each company’s capital structure is different and we want to look at how “risky” a company is regardless of what % debt or equity it has. To get that, we need to un‐lever Beta each time.

But at the end of the calculation, we need to re‐lever it because we want the Beta used in the Cost of Equity calculation to reflect the true risk of our company, taking into account its capital structure this time.

Question 13

Which is higher, cost of debt or cost of equity?

Answer 13

In general, the cost of equity is going to be higher than the cost of debt.

The cost of equity is higher than the cost of debt because the cost associated with borrowing debt financing (i.e., interest expense) is tax-deductible, creating a tax shield – whereas, dividends to common and preferred shareholders are not tax-deductible.

Further, unlike lenders, equity holders have the lowest priority claim under a liquidation scenario because of their placement at the very bottom of the capital structure.

Question 14

What is Precedent Transaction Analysis?

Answer 14

The precedent transaction method has you look at a group of companies similar to the one you are valuing, see what kind of prices they have been bought and sold for, and apply a similar valuation method to the target company.

For example, you could select a few recent transactions and find the average Transaction Value / EBITDA. Then you take that average multiple and multiply it by the target companies EBITDA value to find an implied transaction value for the company.

Question 15

What is Comparable Analysis?

Answer 15

This method attempts to find a group of companies which are comparable to the target company and to work out a valuation based on what they are worth.

The idea is to look for companies in the same sector and with similar financial statistics (Price to Earnings, Book Value, Free Cash Flow, EBITDA etc) and then assume that the companies should be priced relatively similarly.

Some of the most commonly used multiples are:
* Price to Earnings
* Enterprise Value / EBITDA
* Return on Equity
* Return on Assets
* Price to Book Value

Question 16

How do you select Comparable Companies / Precedent Transactions?

Answer 16

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

For Precedent Transactions, you often limit the set based on date and only look at transactions within the past 1‐2 years.

The most important factor is industry – that is always used to screen for companies/transactions, and the rest may or may not be used depending on how specific you want to be.

Question 17

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

Answer 17

There is no ranking that always holds. In general, Precedent Transactions will be higher than Comparable Companies due to the Control Premium built into acquisitions.

Beyond that, a DCF could go either way and you’d say it’s more variable than other methodologies. Often it produces the highest value, but it can produce the lowest value as well depending on your assumptions.

Question 18

What are the most common multiples used in Valuation?

Answer 18

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

Question 19

Walk me through a basic merger model.

Answer 19

A merger model is used to analyze the financial profiles of 2 companies, the purchase price and how the purchase is made, and determines whether the buyer’s EPS increases or decreases.

Step 1 is making assumptions about the acquisition – the price and whether it was cash, stock or debt or some combination of those. Next, you determine the valuations and shares outstanding of the buyer and seller and project out an Income Statement for each one.

Finally, you combine the Income Statements, adding up line items such as Revenue and Operating Expenses, and adjusting for Foregone Interest on Cash and Interest Paid on Debt in the Combined Pre‐Tax Income line; you apply the buyer’s Tax Rate to get the Combined Net Income, and then divide by the new share count to determine the combined EPS.

Question 20

What are the most important factors in an M&A model?

Answer 20

1. Synergies: enables the acquirer to realise value by increasing value or reducing costs (typically this biggest driver of value in an M&A deal, albeit very hard to estimate and can often be overly optimistic)
2. Form of consideration: mix of cash or shares can have a major impact on accretion or dilution of per-share metrics (e.g., EPS). To make a deal more accretive, the acquirer can add more cash to the mix and issue fewer shares
3. Purchase price and takeover premium

Question 21

Why would a company want to acquire another company?

Answer 21

• The buyer wants to gain market share by buying a competitor
• The buyer needs to grow more quickly and sees an acquisition as a way to do that.
• The buyer believes the seller is undervalued
• The buyer wants to acquire the seller’s customers so it can up‐sell and cross‐sell to
• them
• The buyer thinks the seller has a critical technology, intellectual property or some
• other “secret sauce” it can use to significantly enhance its business
• The buyer believes it can achieve significant synergies and therefore make the deal
• accretive for its shareholders

Question 22

What indicators would quickly tell you if an M&A deal is accretive or dilutive?

Answer 22

You can compare their P/E multiples. The company with a higher P/E multiple can acquire lesser valued companies on an accretive basis (assuming the takeover premium is not too high). Another important factor is the form of consideration and mix of cash vs. share.

Question 23

Why would an acquisition be dilutive?

Answer 23

An acquisition is dilutive if the additional amount of Net Income the seller contributes is not enough to offset the buyer’s foregone interest on cash, additional interest paid on debt, or the effects of issuing additional shares.

Acquisition effects – such as amortization of intangibles – can also make an acquisition dilutive.

Question 24

What is enterprise value?

Answer 24

EV adds together a company’s market cap (how much its publicly traded shares are worth) and total debt minus any highly-liquid assets, like cash or savings.

The amount of debt gets adjusted by subtracting cash from it because, in theory, when a company has been acquired, the acquirer can use the target company’s cash to pay a portion of the assumed debt.