Valuation Methods, DCF, & LBO Flashcards
Walk me through a DCF.
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 a company’s financials using assumptions for revenue growth, margins, and the Change in Working Capital; then you calculate Free Cash Flow for each year, which you discount and sum up to get to the Present Value of Free Cash Flows. The Discount Rate is usually the Weighted Average Cost of Capital.
Once you have the present value of the Free Cash Flows, you determine the company’s Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then you discount that back to its Present Value using the Discount Rate.
Finally, you add the two together to determine the company’s implied Enterprise Value, after which you may then back into the implied Equity Value and implied share price.
(forecast CFs, Discount to PV, Forecast TV, Discount to PV, Sum to EV)
Walk me through an LBO.
In an LBO Model, Step 1 is making assumptions about the Purchase Price, Debt/Equity ratio, Interest Rate on Debt, and other variables; you might also assume something about the company’s operations, such as Revenue Growth or Margins, depending on how much information you have.
Step 2 is to create a Sources & Uses section, which shows how the transaction is financed and what the capital is used for; it also tells you how much Investor Equity (cash) is required.
Step 3 is to adjust the company’s Balance Sheet for the new Debt and Equity figures, allocate the purchase price, and add in Goodwill & Other Intangibles on the Assets side to make everything balance.
In Step 4, you project out the company’s Income Statement, Balance Sheet and Cash Flow Statement, and determine how much debt is paid off each year, based on the available Cash Flow and the required Interest Payments.
Finally, in Step 5, you make assumptions about the exit after several years, usually assuming an EBITDA Exit Multiple, and calculate the return based on how much equity is returned to the firm.
What is equity value?
Equity value, commonly referred to as the market value of equity or market capitalization, can be defined as the total value of the company that is attributable to equity investors. It is calculated by multiplying a company’s share price by its number of shares outstanding.
What is enterprise value?
Enterprise Value (EV) is the measure of a company’s total value. It looks at the entire market value rather than just the equity value, so all ownership interests and asset claims from both debt and equity are included. EV can be thought of as the effective cost of buying a company or the theoretical price of a target company (before a takeover premium is considered).
EV = Market Capitalization + Market Value of Debt – Cash and Equivalents
What is terminal value?
In financial analysis, the terminal value includes the value of all future cash flows outside of a particular projection period. It captures values that are otherwise difficult to predict using the regular financial model forecast period. There are two methods used to calculate the terminal value, which depends on the type of analysis to be done.
The exit multiple method assumes the business is sold for a multiple of some metric (e.g., EBITDA) based on currently observed comparable trading multiples for similar businesses.
The perpetuity growth model assumes that cash flow values grow at a constant rate ad infinitum. Because of this assumption, the formula for perpetuity with growth can be used. The perpetuity growth model is preferred among academics as there is a mathematical theory behind it. However, it is difficult to agree on the assumptions that will predict an accurate perpetual growth rate. Can use inflation rate or GDP growth.
What is IRR?
The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a project zero. Put another way, the initial cash investment for the beginning period will be equal to the present value of the future cash flows of that investment. (Cost paid = present value of future cash flows, and hence, the net present value = 0).
Once the internal rate of return is determined, it is typically compared to a company’s hurdle rate or cost of capital. If the IRR is greater than or equal to the cost of capital, the company would accept the project as a good investment. (That is, of course, assuming this is the sole basis for the decision.
Why would a company restructure itself?
Restructuring is when a company makes significant changes to its financial or operational structure, typically while under financial duress.
Companies may also restructure when preparing for a sale, buyout, merger, change in overall goals, or transfer of ownership.
Following a restructuring, the company should be left with smoother, more economically sound business operations.
