Valuation Questions - Basic

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

There is no ranking that always holds true. 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?

Answer 4

1. 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.
2. Replacement Value – Valuing a company based on the cost of replacing its assets.
3. LBO Analysis – Determining how much a PE firm could pay for a company to hit a “target” IRR, usually in the 20-25% range.
4. Sum of the Parts – Valuing each division of a company separately and adding them together at the end.
5. 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.
6. 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 typically used when a company has completely different, unrelated divisions, such as conglomerates like General Motors. When a company operates multiple distinct divisions, you would not use the same set of Comparable Companies and Precedent Transactions for the entire company. Instead, you would 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

You would use an LBO Analysis not only to evaluate a potential leveraged buyout but also to determine how much a private equity firm could afford to pay for a company. This amount is often lower than what companies might be willing to pay.

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).

Question 9

What are some examples of industry-specific multiples?

Answer 9

1. For Technology and Energy, you’re looking at traffic and energy reserves as value drivers rather than revenue or profit. So some common multiples are;
   a. Technology (Internet): EV / Unique Visitors, EV / Pageviews
   b. Energy: P / MCFE, P / MCFE / D (MCFE = 1 Million Cubic Foot Equivalent, MCFE/D = MCFE per Day), P / NAV (Share Price / Net Asset Value)
2. For Retail / Airlines, it’s EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rent), although you would often remove Rent because it is a major expense and one that varies significantly between different types of companies.
3. For Real Estate Investment Trusts (REITs), there’s Price / FFO, Price / AFFO (Funds From Operations, Adjusted Funds From Operations). FFO 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 rather than Equity Value because Enterprise Value represents the total value available to all investors, including both debt and equity holders. In contrast, Equity Value only reflects the value available to shareholders. Since metrics such as the number of scientists or subscribers affect the entire company and its total operations, Enterprise Value provides a more comprehensive measure of value that is relevant to all investors.

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 a lower valuation. With an LBO, you don’t 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.

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).

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, not just equity holders. Similarly, Enterprise Value reflects the value available to all shareholders, so it makes sense to pair these two together. In contrast, Equity Value reflects only what’s available to equity investors and does not account for the company’s entire capital structure.

Question 15

When would a Liquidation Valuation produce the highest value?

Answer 15

Although this is uncommon, it can happen if a company had substantial hard assets that the market was severely undervaluing for a specific reason (such as an earnings miss or cyclicality), making the assets easy to sell off.

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

I would use Comparable Companies and Precedent Transactions and look at more unique multiples such as EV/Unique Visitors and EV/Pageviews. I would avoid using a DCF because you can’t reasonably predict cash flows for a company that isn’t even producing revenue yet.

Question 17

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

Answer 17

Depends. For Unlevered Free Cash Flow, you would use Enterprise Value, but for Levered Free Cash Flow you would use Equity Value. Unlevered Free Cash Flow excludes Interest and thus represents money available to all investors, whereas Levered already includes Interest and the money is therefore only available to equity investors.

Question 18

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

Answer 18

It’s rare to see, but sometimes large financial institutions with major cash balances may have negative Enterprise Value so you might use Equity Value / Revenue instead. However, in most cases, you would be using other multiples such as P/E and P/BV instead.

Question 19

How do you select Comparable Companies / Precedent Transactions?

Answer 19

The 3 main ways to select companies and transactions are based on; industry classification, financial criteria (Revenue, EBITDA, etc.), and geography. For Precedent Transactions, you want to limit the set based on date and only look at the transactions within the past 1-2 years. Industry is the most important factor. It is always used to screen for companies and transactions. The other two may or may not be used depending on how specific you want to get. A few examples could be:
1. Comparable Company Screen: Oil & gas producers with market caps over $5 billion.
2. Comparable Company Screen: Digital media companies with over $100 million in revenue.
3. Precedent Transaction Screen: Airline M&A transactions over the past 2 years involving sellers with over $1 billion in revenue.
4. 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

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. For 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

You use valuations in pitchbooks and client presentations when providing updates and explaining what clients can expect in their own valuation. Valuations are also used in defense analyses, merger models, LBO models, and DCFs, as the terminal value is based on comps. Additionally, valuations are applied right before a deal closes in a Fairness Opinion document to ensure that what a client is paying or receiving is ‘fair’ from a financial perspective.

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 several reasons:
1. The company has reported higher-than-expected earnings and had an increase in its stock price.
2. The company has some type of competitive advantage not reflected in its financials, such as a patent or intellectual property.
3. It has just won a favorable ruling in a recent lawsuit.
4. 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

1. No two companies are 100% comparable to each other.
2. The stock market is highly volatile - your multiples might be dramatically higher or lower on certain dates depending on market sentiment.
3. Share prices for small companies with thinly traded stocks are extremely volatile and unreliable as they may not reflect the company’s 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.

Question 25

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

Answer 25

It depends on the company and its performance. You typically use the median multiple, but if a company is distressed or at a competitive disadvantage, you might use the 25th percentile or a lower range. Conversely, if the company is performing exceptionally well, you could use a higher range instead.

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

This can happen sometimes 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.

Question 27

What are some flaws with precedent transactions?

Answer 27

1. Past transactions are rarely 100% comparable – the transaction structure, size of the company, and market sentiment all have huge effects.
2. 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 profile 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

Some possible reasons could be:
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. Or they were just in industries with different median multiples.

Question 29

Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?

Answer 29

Warren Buffet dislikes EBITDA because it excludes the often sizeable Capital Expenditures companies make, exaggerating how much cash they actually have to finance their operations. In some industries, the gap between EBIT and EBITDA is so large, that anything that is very capital-intensive, will show a disparity.

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 with large cash balances and interest payments/expenses. EV / EBIT includes Depreciation & Amortization whereas EV / EBITDA excludes it. You’re more likely to use EV /EBIT in industries where D&A is a large and significant amount and where CapEx and fixed assets are important (ex. manufacturing). You would use EV / EBITDA in industries where CapEx and fixed assets aren’t that important and D&A is significantly smaller (ex. 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 leased the machines. Enterprise Value would be the same for both companies, but in the depreciated situation, the charge would not be reflected in EBITDA, so the EBITDA would be higher, resulting in a low EV / EBITDA multiple. In the leased situation, the lease would show up in SG&A and 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 would use the same methodologies as with a public company (public company comparables, precedent transactions, DCF, etc.) but with a few key differences.
1. 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.
2. You wouldn’t be able to use a premiums analysis or future share price analysis because a private company doesn’t have a share price.
3. Your valuation would show the Enterprise Value for the company as opposed to the implied per-share price as with public companies.
4. A DCF could get 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 an entire company, and when a company is acquired, its shares become illiquid. Shares can be either liquid (public) or illiquid (private), and because 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 for 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.