Valuation Questions & Answers

Question 1

What are the 3 major valuation methodologies?

Answer 1

Comparable Companies, Precedent Transactions and Discounted Cash Flow Analysis.

Question 2

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

Answer 2

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

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

Question 3

When would you not use a DCF in a Valuation?

Answer 3

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

Question 4

What other Valuation methodologies are there outside of the main 3?

Answer 4

Other methodologies include:

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

Question 5

When would you use a Liquidation Valuation?

Answer 5

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

Question 6

When would you use Sum of the Parts?

Answer 6

This is most often used when a company has completely different, unrelated divisions - a conglomerate like General Electric, for example.

If you have a plastics division, a TV and entertainment division, an energy division, a consumer financing division and a technology division, you should not use the same set of Comparable Companies and Precedent Transactions for the entire company.

Instead, you should use different sets for each division, value each one separately, and then add them together to get the Combined Value.

Question 7

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

Answer 7

Obviously you use this whenever you’re looking at a Leveraged Buyout - but it is also used to establish how much a private equity firm could pay, which is usually lower than what companies will pay.

It is often used to set a “floor” on a possible Valuation for the company you’re looking at.

Question 8

What are the most common multiples used in Valuation?

Answer 8

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

Question 9

What are some examples of industry-specific multiples?

Answer 9

Technology (Internet): EV / Unique Visitors, EV / Pageviews

Retail / Airlines: EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rental Expense)

Energy: EV / EBITDAX (Earnings Before Interest, Taxes, Depreciation, Amortization & Exploration Expense), EV / Daily Production, EV / Proved Reserve Quantities

Real Estate Investment Trusts (REITs): Price / FFO per Share, Price / AFFO per Share (Funds From Operations, Adjusted Funds From Operations)

Technology and Energy should be straightforward - you’re looking at traffic and energy reserves as value drivers rather than revenue or profit.

For Retail / Airlines, you add back Rent because some companies own their own buildings and capitalize the expense whereas others rent and therefore have a rental expense.

For Energy, all value is derived from companies’ reserves of oil & gas, which explains the last 2 multiples; EBITDAX exists because some companies capitalize (a portion of) their exploration expenses and some expense them. You add back the exploration expense to normalize the numbers.

For REITs, Funds From Operations is a common metric that adds back Depreciation and subtracts gains on the sale of property. Depreciation is a non-cash yet extremely large expense in real estate, and gains on sales of properties are assumed to be non-recurring, so FFO is viewed as a “normalized” picture of the cash flow the REIT is generating.

Question 10

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

Answer 10

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

Question 11

Would an LBO or DCF give a higher valuation?

Answer 11

Technically it could go either way, but in most cases the LBO will give you a lower valuation.

Here’s the easiest way to think about it: with an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year - you’re only valuing it based on its terminal value.

With a DCF, by contrast, you’re taking into account both the company’s cash flows in between and its terminal value, so values tend to be higher.

Note: Unlike a DCF, an LBO model by itself does not give a specific valuation. Instead, you set a desired IRR and determine how much you could pay for the company (the valuation) based on that.

Question 12

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

Answer 12

Usually you use a “football field” chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number.

Question 13

How would you value an apple tree?

Answer 13

The same way you would value a company: by looking at what comparable apple trees are worth (relative valuation) and the value of the apple tree’s cash flows (intrinsic valuation).

Yes, you could do a DCF for anything - even an apple tree.

Question 14

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

Answer 14

EBITDA is available to all investors in the company - rather than just equity holders. Similarly, Enterprise Value is also available to all shareholders so it makes sense to pair them together.

Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect the company’s entire capital structure - only the part available to equity investors.

Question 15

When would a Liquidation Valuation produce the highest value?

Answer 15

This is highly unusual, but it could happen if a company had substantial hard assets but the market was severely undervaluing it for a specific reason (such as an earnings miss or cyclicality).

As a result, the company’s Comparable Companies and Precedent Transactions would likely produce lower values as well - and if its assets were valued highly enough, Liquidation Valuation might give a higher value than other methodologies.

Question 16

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

Answer 16

You would use Comparable Companies and Precedent Transactions and look at more “creative” multiples such as EV/Unique Visitors and EV/Pageviews rather than EV/Revenue or EV/EBITDA.

You would not use a “far in the future DCF” because you can’t reasonably predict cash flows for a company that is not even making money yet.

This is a very common wrong answer given by interviewees. When you can’t predict cash flow, use other metrics - don’t try to predict cash flow anyway!

Question 17

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

Answer 17

Trick question. For Unlevered Free Cash Flow, you would use Enterprise Value, but for
Levered Free Cash Flow you would use Equity Value.

Remember, Unlevered Free Cash Flow excludes Interest and thus represents money available to all investors, whereas Levered FCF already includes the effects of the

Interest expense (and mandatory debt repayments) and the money is therefore only available to equity investors.

Debt investors have already “been paid” with the interest payments and principal re payments they received.

Question 18

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

Answer 18

It’s very rare to see this, but sometimes large financial institutions with big cash balances have negative Enterprise Values - so you might use Equity Value / Revenue instead.

You might see Equity Value / Revenue if you’ve listed a set of financial institutions and non-financial institutions on a slide, you’re showing Revenue multiples for the non- financial institutions, and you want to show something similar for the financial institutions.

Note, however, that in most cases you would be using other multiples such as P/E and P/BV with banks anyway.

Question 19

How do you select Comparable Companies / Precedent Transactions?

Answer 19

The 3 main ways to select companies and transactions:

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

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

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

Here are a few examples:

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

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

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

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

Question 20

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

Answer 20

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

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

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

Question 21

What do you actually use a valuation for?

Answer 21

Usually you use it in pitch books and in client presentations when you’re providing updates and telling them what they should expect for their own valuation.

It’s also used right before a deal closes in a Fairness Opinion, a document a bank creates that “proves” the value their client is paying or receiving is “fair” from a financial point of view.

Valuations can also be used in defense analyses, merger models, LBO models, DCFs (because terminal multiples are based off of comps), and pretty much anything else in finance.

Question 22

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

Answer 22

This could happen for a number of reasons:

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

Question 23

What are the flaws with public company comparables?

Answer 23

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

Question 24

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

Answer 24

1. Look at the 75th percentile or higher for the multiples rather than the Medians.
2. Add in a premium to some of the multiples.
3. Use more aggressive projections for the company.

In practice you rarely do all of the above - these are just possibilities.

Question 25

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

Answer 25

There’s no “rule” that you have to do this, but in most cases you do because you want to use values from the middle range of the set. But if the company you’re valuing is distressed, is not performing well, or is at a competitive disadvantage, you might use the 25th percentile or something in the lower range instead - and vice versa if it’s doing well.

Question 26

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

Answer 26

Sometimes this happens when there is a substantial mismatch between the M&A market and the public market. For example, no public companies have been acquired recently

but there have been a lot of small private companies acquired at extremely low valuations.

For the most part this generalization is true but there are exceptions to almost every “rule” in finance.

Question 27

What are some flaws with precedent transactions?

Answer 27

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

Question 28

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

Answer 28

Possible reasons:

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

Question 29

Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?

Answer 29

Warren Buffett once famously said, “Does management think the tooth fairy pays for capital expenditures?”

He dislikes EBITDA because it hides the Capital Expenditures companies make and disguises how much cash they are actually using to finance their operations.

In some industries there is also a large gap between EBIT and EBITDA - anything that is very capital-intensive, for example, will show a big disparity.

Note that EBIT itself does not include Capital Expenditures, but it does include Depreciation and that is directly linked to CapEx - that’s the link. If a company has a high Depreciation expense, chances are it has a high CapEx.

Question 30

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

Answer 30

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

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

Question 31

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

Answer 31

You would pay more for the one where you lease the machines. Enterprise Value would be the same for both companies, but with the depreciated situation the charge is not reflected in EBITDA - so EBITDA is higher, and the EV / EBITDA multiple is lower as a result. For the leased situation, the lease would show up in SG&A so it would be reflected in EBITDA, making EBITDA lower and the EV / EBITDA multiple higher.

Question 32

How do you value a private company?

Answer 32

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

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

Question 33

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

Answer 33

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

But shares - the ability to buy individual “pieces” of a company rather than the whole thing - can be either liquid (if it’s public) or illiquid (if it’s private).

Since shares of public companies are always more liquid, you would discount public company comparable multiples to account for this.

Question 34

Can you use private companies as part of your valuation?

Answer 34

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

Question 35

How do you value banks and financial institutions differently from other companies?

Answer 35

For relative valuation, the methodologies (public comps and precedent transactions) are the same but the metrics and multiples are different:

• You screen based on assets or deposits in addition to the normal criteria.
• You look at metrics like ROE (Return on Equity, Net Income / Shareholders’ Equity), ROA (Return on Assets, Net Income / Total Assets), and Book Value and Tangible Book Value rather than Revenue, EBITDA, and so on.
  
  • You use multiples such as P / E, P / BV, and P / TBV rather than EV / EBITDA. Rather than a traditional DCF, you use 2 different methodologies for intrinsic valuation:
• In a Dividend Discount Model (DDM) you sum up the present value of a bank’s dividends in future years and then add it to the present value of the bank’s terminal value, usually basing that on a P / BV or P / TBV multiple.
• In a Residual Income Model (also known as an Excess Returns Model), you take the bank’s current Book Value and simply add the present value of the excess returns to that Book Value to value it. The “excess return” each year is (ROE * Book Value) - (Cost of Equity * Book Value) - basically how much the returns exceed your expectations.

You need to use these methodologies and multiples because interest is a critical component of a bank’s revenue and because debt is a “raw material” rather than just a financing source; also, banks’ book values are usually very close to their market caps.

Question 36

Walk me through an IPO valuation for a company that’s about to go public.

Answer 36

1. Unlike normal valuations, in an IPO valuation we only care about public company comparables.
2. After picking the public company comparables we decide on the most relevant multiple to use and then estimate our company’s Enterprise Value based on that.
3. Once we have the Enterprise Value, we work backward to get to Equity Value
   and also subtract the IPO proceeds because this is “new” cash.
4. Then we divide by the total number of shares (old and newly created) to get its per-share price. When people say “An IPO priced at…” this is what they’re referring to.

If you were using P / E or any other “Equity Value-based multiple” for the multiple in step #2 here, then you would get to Equity Value instead and then subtract the IPO proceeds from there.

Question 37

I’m looking at financial data for a public company comparable, and it’s April (Q2) right now. Walk me through how you would “calendarize” this company’s financial statements to show the Trailing Twelve Months as opposed to just the last Fiscal Year.

Answer 37

The “formula” to calendarize financial statements is as follows:

TTM = Most Recent Fiscal Year + New Partial Period - Old Partial Period

So in the example above, we would take the company’s Q1 numbers, add the most recent fiscal year’s numbers, and then subtract the Q1 numbers from that most recent fiscal year.

For US companies you can find these quarterly numbers in the 10-Q; for international companies they’re in the interim reports.

Question 38

Walk me through an M&A premiums analysis.

Answer 38

The purpose of this analysis is to look at similar transactions and see the premiums that buyers have paid to sellers’ share prices when acquiring them. For example, if a company is trading at $10.00/share and the buyer acquires it for $15.00/share, that’s a 50% premium.

1. First, select the precedent transactions based on industry, date (past 2-3 years for example), and size (example: over $1 billion market cap).
2. For each transaction, get the seller’s share price 1 day, 20 days, and 60 days before the transaction was announced (you can also look at even longer intervals, or 30 days, 45 days, etc.).
3. Then, calculate the 1-day premium, 20-day premium, etc. by dividing the per- share purchase price by the appropriate share prices on each day.
4. Get the medians for each set, and then apply them to your company’s current share price, share price 20 days ago, etc. to estimate how much of a premium a buyer might pay for it.

Note that you only use this analysis when valuing public companies because private companies don’t have share prices. Sometimes the set of companies here is exactly the same as your set of precedent transactions but typically it is broader.

Question 39

Walk me through a future share price analysis.

Answer 39

The purpose of this analysis is to project what a company’s share price might be 1 or 2 years from now and then discount it back to its present value.

1. Get the median historical (usually TTM) P / E of your public company comparables.
2. Apply this P / E multiple to your company’s 1-year forward or 2-year forward projected EPS to get its implied future share price.
3. Then, discount this back to its present value by using a discount rate in-line with the company’s Cost of Equity figures.

You normally look at a range of P / E multiples as well as a range of discount rates for this type of analysis, and make a sensitivity table with these as inputs.

Question 40

Both M&A premiums analysis and precedent transactions involve looking at previous M&A transactions. What’s the difference in how we select them?

Answer 40

• All the sellers in the M&A premiums analysis must be public.
• Usually we use a broader set of transactions for M&A premiums - we might use fewer than 10 precedent transactions but we might have dozens of M&A premiums. The industry and financial screens are usually less stringent.
• Aside from those, the screening criteria is similar - financial, industry, geography, and date.

Question 41

Walk me through a Sum-of-the-Parts analysis.

Answer 41

In a Sum-of-the-Parts analysis, you value each division of a company using separate comparables and transactions, get to separate multiples, and then add up each division’s value to get the total for the company. Example:

We have a manufacturing division with $100 million EBITDA, an entertainment division with $50 million EBITDA and a consumer goods division with $75 million EBITDA. We’ve selected comparable companies and transactions for each division, and the median multiples come out to 5x EBITDA for manufacturing, 8x EBITDA for entertainment, and 4x EBITDA for consumer goods.

Our calculation would be $100 * 5x + $50 * 8x + $75 * 4x = $1.2 billion for the company’s total value.

Question 42

How do you value Net Operating Losses and take them into account in a valuation?

Answer 42

You value NOLs based on how much they’ll save the company in taxes in future years, and then take the present value of the sum of tax savings in future years. Two ways to assess the tax savings in future years:

1. Assume that a company can use its NOLs to completely offset its taxable income until the NOLs run out.
2. In an acquisition scenario, use Section 382 and multiply the adjusted long-term rate (http://pmstax.com/afr/exemptAFR.shtml) by the equity purchase price of the seller to determine the maximum allowed NOL usage in each year - and then use that to figure out the offset to taxable income.

You might look at NOLs in a valuation but you rarely add them in - if you did, they would be similar to cash and you would subtract NOLs to go from Equity Value to Enterprise Value, and vice versa.

Question 43

I have a set of public company comparables and need to get the projections from equity research. How do I select which report to use?

Answer 43

This varies by bank and group, but two common methods:

1. You pick the report with the most detailed information.
2. You pick the report with numbers in the middle of the range.

Note that you do not pick reports based on which bank they’re coming from. So if you’re at Goldman Sachs, you would not pick all Goldman Sachs equity research - in fact that would be bad because then your valuation would not be objective.

Question 44

I have a set of precedent transactions but I’m missing information like EBITDA for a lot of the companies - how can I find it if it’s not available via public sources?

Answer 44

1. Search online and see if you can find press releases or articles in the financial press with these numbers.
2. Failing that, look in equity research for the buyer around the time of the transaction and see if any of the analysts estimate the seller’s numbers.
3. Also look on online sources like Capital IQ and Factset and see if any of them disclose numbers or give estimates.

Question 45

How far back and forward do we usually go for public company comparable and precedent transaction multiples?

Answer 45

Usually you look at the TTM (Trailing Twelve Months) period for both sets, and then you look forward either 1 or 2 years. You’re more likely to look backward more than 1 year and go forward more than 2 years for public company comparables; for precedent transactions it’s odd to go forward more than 1 year because your information is more limited.

Question 46

I have one company with a 40% EBITDA margin trading at 8x EBITDA, and another company with a 10% EBITDA margin trading at 16x EBITDA. What’s the problem with comparing these two valuations directly?

Answer 46

There’s no “rule” that says this is wrong or not allowed, but it can be misleading to compare companies with dramatically different margins. Due to basic arithmetic, the 40% margin company will usually have a lower multiple - whether or not its actual value is lower.

In this situation, we might consider screening based on margins and remove the outliers - you would never try to “normalize” the EBITDA multiples based on margins.

Question 47

Walk me through how we might value an oil & gas company and how it’s different from a “standard” company.

Answer 47

Public comps and precedent transactions are similar, but:

• You might screen based on metrics like Proved Reserves or Daily Production.
• You would look at the above metrics as well as R/P (Proved Reserves / Last Year’s Production), EBITDAX, and other industry-specific ones, and use matching multiples.

You could use a standard Unlevered DCF to value an oil & gas company as well, but it’s also common to see a NAV (Net Asset Value) Model where you take the company’s Proved Reserves, assume they produce revenue until depletion, assign a cost to the production in each year, and take the present value of those to value the company.

There are also a host of other complications: oil & gas companies are cyclical and have no control over the prices they receive, companies use either “full-cost accounting” or “successful efforts accounting” and treat the exploration expense differently, and so on.

Question 48

Walk me through how we would value a REIT (Real Estate Investment Trust) and how it differs from a “normal” company.

Answer 48

Similar to energy, real estate is asset-intensive and a company’s value depends on how much cash flow specific properties generate.

• You look at Price / FFO per Share (Funds From Operations) and Price / AFFO per Share (Adjusted Funds From Operations), which add back Depreciation and subtract gains on property sales.
• A Net Asset Value (NAV) model is the most common intrinsic valuation methodology; you assign a cap rate to the company’s forward NOI and multiply to get the value of its real estate, adjust and add its other assets, subtract liabilities and divide by its share count to get NAV per Share, and then compare that to its current share price.
• You value properties by dividing Net Operating Income (NOI) (Property’s Gross Income - Operating Expenses and Property Taxes) by the capitalization rate (based on market data).
• Replacement Valuation is more common because you can actually estimate the cost of buying new land and building new properties.
• A DCF is still a DCF, but it flows from specific properties and it might be useless depending on what kind of company you’re valuing.