Valuation REFINED

Question 1

What is EBIT?

Answer 1

Earnings Before Interest & Taxes: This is the firm’s operating income from the I/S (Revenue - COGS - Operating Expenses). This includes impact of depreciation‚ amortization and other non-cash charges

Question 2

What is EBITDA?

Answer 2

• Earnings Before Interest‚ Taxes‚ Depreciation & Amortization: The idea is to remove most non-cash charges and make it more accurately reflect cash flow potential (proxy for free cash flow).
• You may add back other non-cash charges‚ such as stock-based compensation.

Question 3

How do you get unlevered free cash flows (free cash flow to firm)?

Answer 3

EBIT*(1 - tax rate) + Non-cash charges - changes in operating assets and liabilities - CapEx

Question 4

How do you get levered free cash flows (free cash flow to equity)?

Answer 4

Net Income + Non-Cash Charges - changes in operating assets and liabilities - CapEx - Mandatory Debt Payments

Question 5

What is the Enterprise Value / EBIT multiple used for? What does it mean?

Answer 5

• Used for many types of companies‚ mostly useful for those where CapEx is more important to factor in (since D&A flows CapEx closely)
• It’s a rough approximation of how valuable a company is relative to its income from business operations

Question 6

What is the Enterprise Value / EBITDA multiple used for? What does it mean?

Answer 6

• Used for many types of companies‚ most useful for those where CapEx and D&A are not as important since it excludes both.
• It’s a rough approximation of how valuable a company is relative to its operational cash flow

Question 7

What is the Enterprise Value / Unlevered FCF multiple used for? What does it mean?

Answer 7

• Used when CapEx or changes in operational assets and liabilities such as Deferred Revenue have a big impact‚ also critical in DCFs
• It’s similar to Levered FCF‚ but it’s capital structural-neutral‚ so it’s better for comparing different companies

Question 8

Of the valuation multiples‚ which are the most common? Which is the “worst”?

Answer 8

• EV/EBITDA and EV/EBIT are the most common.
• P/E is probably the “worst” or “least accurate” since it includes non-cash charges and impacted by tax rates and capital structure. P/E more commonly used among general public than finance professionals.

Question 9

Can you walk me through how to calculate EBIT and EBITDA? How are they different?

Answer 9

• EBIT is just a company’s operating income on its I/S‚ it includes not only COGS and operating expenses‚ but also non-cash expenses such as D&A and therefore reflects‚ at least indirectly‚ the company’s CapEx
• EBITDA is defined as EBIT plus D&A. You may sometimes add back other expenses
• The idea of EBITDA is to move closer to a company’s “cash flow‚” since D&A are non-cash expenses‚ but the problem is that you exclude CapEx altogether

Question 10

Can you walk me through how to calculate Unlevered FCF (FCF to Firm) and Levered FCF (FCF to Equity)?

Answer 10

• Unlevered FCF = EBIT*(1 - Tax Rate) + Non-cash expenses - Change in Operating Assets & Liabilities - CapEx
• Levered FCF = Net Income + Non-Cash expenses - Change in Operating Assets & Liabilities - CapEx - Mandatory Debt Repayments

Question 11

What are the most common valuation multiples? And what do they mean?

Answer 11

• EV/Revenue: how valuable a company is relative to its overall sales

• EV/EBITDA: how valuable a company is relative to its approximate cash flow
• EV/EBIT: how valuable a company is relative to the pre-tax profit it earns from its core business operations
• P/E: how valuable a company is in relation to its after-tax profits‚ inclusive of interest income and expense and other non-core business activities
• Other multiples include P/BV‚ EV/Unlevered FCF‚ Equity Value/Levered FCF
• EV/Unlevered FCF is closer to true cash flow than EV/EBITDA but takes more work to calculate‚ and Equity Value/Levered FCF is even closer‚ but is affected by company’s capital structure and takes even more time to calculate.

Question 12

How are the key operating metrics and valuation multiples correlated? In other words‚ what might explain a higher or lower EV/EBITDA multiple?

Answer 12

• Usually there is a correlation between growth and valuation multiples
• Math also plays a role‚ sometimes companies w/ extremely high EBITDA margins may have lower EBITDA multiples because EBITDA itself is much higher to begin with (and its in the denominator)

Question 13

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

Answer 13

Equity Value/EBITDA is comparing apples to oranges because equity value does not reflect the company’s entire capital structure (only what is available to common shareholders).

Question 14

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

Answer 14

• For Unlevered FCF‚ you use enterprise value (cash flow available to all investors)
• For Levered FCF‚ you use equity value (cash flow available to equity investors)

Question 15

Why does Warren Buffet prefer EBIT multiples to EBITDA multiples?

Answer 15

• WB dislikes EBITDA b/c it hides the CapEx companies make and disguises how much cash they require to finance their operations
• Any industry that is capital intensive and asset-heavy will have a huge disparity between EBIT and EBITDA
• Note: EBIT itself does NOT include CapEx but it includes depreciation (which is directly linked to CapEx). If a company has high depreciation‚ chances are it has high CapEx spending

Question 16

What are some problems with EBITDA and EBITDA multiple? And if there are so many problems‚ why do we still use it?

Answer 16

• It hides the amount of debt principal and interest that a company is paying each year‚ which can be very large and make company cash flows negative‚ also hides CapEx spending
• EBITDA also ignores working capital requirements (e.g. A/R‚ Inv.‚ A/P)‚ which can be large for some companies
• In a lot of cases EBITDA may not even be close to true cash flow‚ it’s widely used for convenience and comparability (better for comparing cash generated by a company’s core business operations than other metrics)

Question 17

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 17

• P/E is dependent on company’s capital structure
• P/E is used for financial institutions where interest is critical and capital structures are similar.
• EV/EBIT and EV/EBITDA are capital structure-neutral.
• EV/EBIT includes D&A‚ where EV/EBITDA excludes it
• EV/EBIT in industries where D&A is large and where CapEx and fixed assets is important (manufacturing)
• EV/EBITDA where fixed assets are less important and where D&A is comparatively smaller (e.g. internet companies)

Question 18

Could EV/EBITDA ever be higher than EV/EBIT for the same company?

Answer 18

• No‚ by definition EBITDA must be greater than or equal to EBIT‚ b/c EBITDA = EBIT + D&A (neither of which can be negative‚ can be $0 theoretically)
• Since EBITDA is always greater than or equal to EBIT‚ EV/EBITDA must always be less than or equal to EV/EBIT for a single company

Question 19

What are some examples of industry-specific multiples?

Answer 19

• Technology/Internet: EV/Unique Visitors‚ EV/Page Views
• Retail/Airlines: EV/EBITDAR (EBITDA + Rental Expense)
• Oil & Gas: EV/EBITDAX (EBITDA + Exploration Expense)‚ EV/Production‚ EV/Proved Reserves

• Real Estate Investment Trusts (REITs): Price/FFO per Share‚ Price/AFFO per Share (Funds from Operations‚ Adj. Funds from Operations)

Question 20

When you’re looking at an industry specific multiple like EV/Proved Reserves or EV/Subscribers (for telecom companies‚ for example)‚ why do you use Enterprise Value rather than Equity Value?

Answer 20

• Enterprise Value is used b/c those proved reserves or subscribers are “available” to all the investors (both debt and equity) in a company.
• This is almost always the case unless the metric already includes interest income and expense (FFO & AFFO)

Question 21

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

Answer 21

• Trick question - there is no one ranking that will always hold up.
• In general‚ precedent transactions will be higher than comparable public companies due to the control premium built into acquisitions (buyer must pay premium to acquire seller)
• DCF could go either way‚ best to say it’s just more variable than other methodologies. Often produces highest value‚ but can produce lowest value as well depending on assumptions.

Question 22

Would an LBO or DCF produce a higher valuation?

Answer 22

• Technically‚ could go either way‚ but in most cases LBO gives lower valuation.
• LBOs do not get any value form the cash flows of a company in between Year 1 and the final year‚
• LBOs only get “value” out of its final year
• DCF takes into account both the company’s cash flows in the period itself as well as the terminal value‚ so values tend to be higher
• LBO itself does not give you a valuation‚ you start with a target IRR then back-solve the implied valuation of the company (how much sponsor could pay) - UNLIKE DCF!

Question 23

When would a Liquidation produce the highest value?

Answer 23

Highly unusual‚ but could happen if company has substantial hard assets but market was severely undervaluing it for a specific reason (missed earnings or cyclicality)

Question 24

Why are public comps and precedent transactions sometimes viewed as being “more reliable” than a DCF?

Answer 24

Based on actual market data vs. pure management assumptions about the

SO if the internal forecast is not reliable DCF provides limited reliability

• Note you still need to make future assumptions (Forward Year 1‚ Forward Year 2)
• Also‚ sometimes you may not have good or truly comparable data‚ in which case a DCF might produce better results

Question 25

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 25

• This can occur when there is substantial mismatch between M&A markets and public markets. For example‚ no public companies have been acquired recently but lots of small private companies have been acquired at low valuations

Question 26

What are some flaws with Precedent Transactions?

Answer 26

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

Question 27

How would you present these Valuation methodologies to a company or its investors? And what do you use it for?

Answer 27

• Usually you use a “football field” chart where valuation ranges are implied by each methodology. You ALWAYS show a range rather than one specific number
• You could use a valuation for: 1) pitch books and client presentations‚ 2) parts of other models (defense analyses‚ merger models‚ LBO models‚ DCFs‚ almost everything in finance will incorporate a valuation in some way‚ 3) fairness opinions

Question 28

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

Answer 28

• Company has just reported earnings well above expectations and its stock price has risen in response
• Has some type of competitive advantage not reflected in financials‚ such as a key patent or other intellectual property
• Just won a favorable ruling in a major lawsuit
• Is the market leader in an industry and has greater market share than its competitors

Question 29

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

Answer 29

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

Question 30

Two companies have the exact same financial profiles (revenue‚ growth‚ and profits) and are purchased by the same acquirer‚ but the EBITDA multiple for one transaction is twice the multiple of the other transaction - how could this happen?

Answer 30

• One process was more competitive and had a lot more companies bidding on the target
• One company had recent bad news or a depressed stock price so it was acquired at a discount
• They were in industries w/ different median multiples
• The two companies have different accounting standards and have added back different items when calculating EBITDA‚ so the multiples are not truly comparable

Question 31

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

Answer 31

Higher multiple for the one w/ leased machines‚ all else being equal.

• Purchase Enterprise Value would be the same for both acquisitions‚ but depreciation is excluded from EBITDA‚ so EBITDA is higher (dep. exp. added back)
• For the company w/ the lease‚ the lease expense would show up in operating expenses‚ making EBITDA lower and the EV/EBITDA multiple higher to get to the same EV.

Question 32

The S&P500 Index has a median P/E multiple of 20x. A manufacturing company you’re analyzing has earnings of $1M. How much is the company worth?

Answer 32

Depends on how it’s performing relative to the index and relative to companies in its own industry (outperforming can lead to $25-30M‚ performing on par would be $20M‚ or underperforming would be

Question 33

A company’s current stock price is $20/share and its P/E multiple is 20x‚ so its EPS is $1. It has 10M shares outstanding. Now it does a 2-for-1 stock split - how do its P/E multiple and valuation change?

Answer 33

They don’t

• Company has 20M shares outstanding‚ but equity value has stayed the same‚ so share price will fall to $10‚ EPS falls to $0.50‚ and P/E multiple remains at 20x
• Splitting stock into fewer units or additional units does not‚ by itself‚ make a company worth more or less (in practice‚ a stock split is viewed favorably by the market and a company’s value may go up and it’s share price‚ in this case‚ might not necessarily be cut in half)

Question 34

Let’s say that you’re comparing a company with a strong brand name‚ such as Coca-Cola‚ to a generic manufacturing or transportation company. Both companies have similar growth profiles and margins. Which one will have the higher EV/EBITDA multiple?

Answer 34

• Most likely the firm with the strong brand will get the higher valuation
• Remember that valuation is not a science‚ it’s an art‚ and the market can behave irrationally. Values are not based strictly on financial criteria‚ and other factors such as brand name or “trendiness” can all make an impact.

Question 35

Walk me through an M&A Premiums Analysis.

Answer 35

1. Select the precedent transactions based on industry‚ date and size.
2. For each transaction‚ get the seller’s share price 1 day‚ 20 days‚ 60 days before the transaction was announced‚ i.e. the unaffected share price (you can also look at 90-day intervals‚ or 30 days‚ 45 days‚ etc.)
3. Calculate the 1-day premium‚ 20-day premium‚ etc. by dividing the per-share purchase price by the appropriate share price on each day.
4. Get the medians for each set‚ and then apply them to your company’s share price‚ share price 20 days ago‚ and so on to estimate how much of a premium a buyer might pay for it.

• You only use this when valuing a public company b/c 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 is broader.

Question 36

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

Answer 36

• 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‚ screening criteria are similar‚ financial metrics‚ industry‚ geography‚ and date.

Question 37

Walk me through a Futures Share Price Analysis.

Answer 37

• Purpose is to project company’s share price 1 or 2 years from now and then discount back to present value.

1. Get the median historical (usually Trailing Twelve Months‚ TTM) P/E multiple of the 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. Discount this share price back to its present value by using a discount rate in line with the company’s cost of equity

• Normally look at range of P/E multiples and discount rates (sensitivity table)

Question 38

Walk me through a Sum of the Parts Analysis.

Answer 38

1. Value each division of a company using Comparable Companies and Precedent Transactions.
2. Get to separate multiples for each division and apply to company’s division’s metrics for division valuation.
3. Add up each division’s value to get total value for company

• Picking a range of multiples for each division is crucial

Question 39

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

Answer 39

• You determine how much the NOLs will save the company in taxes in future years‚ and then calculate the NPV of total future tax savings.
• The 2 ways to estimate tax savings in future years:

1) assume that company can use NOLs to completely offset its taxable income until the NOLs run out‚
2) in an acquisition scenario‚ use Section 382 and multiply the highest adjusted long-term rate of the past 3 months by the Equity Purchase Price of the seller to determine the maximum allowed NOL usage in each year - and then use that to determine how much the company can save in taxes.

• Practically speaking‚ you MAY look at NOLs in a valuation‚ but you rarely factor them in. If you did‚ they would be treated similarly to Cash and you would subtract NOLs to go from Equity Value to Enterprise Value‚ and vice versa

Question 40

How do non-recurring charges typically affect valuation multiples?

Answer 40

• Most of the time‚ non-recurring charges typically increase valuation multiples since they reduce metrics such as EBIT‚ EBITDA‚ and EPS. You could have non-recurring income as well (e.g. a one-time asset sale) which would have the opposite effect

Question 41

You’re analyzing a transaction where the buyer acquired 80% of the seller for $500M. The seller’s revenue was $300M and its EBITDA was $100M. It also had $50M in cash and $100M in debt. What were the revenue and EBITDA multiples for this deal?

Answer 41

1. Equity Value = $500M/80% = $625M
2. Enterprise Value = Equity Value - Cash + Debt = $625M - $50M + $100M = $675M
3. Revenue Multiple = $675M / $300M = 2.25x
4. EBITDA Multiple = $675M / $100M = 6.75x

Question 42

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 42

• It can be misleading to compare companies w/ drastically different margins. Due to basic math‚ the 40% margin company will usually have a lower multiple (whether or not its actual value is lower)
• In this situation‚ might want to consider screening based on margins and remove the outliers - you would not try to “normalize” the EBITDA multiples based on margins.

Question 43

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

Answer 43

1. Unlike normal valuations‚ in an IPO valuation‚ we only care about public company comparables (we select them as we normally would).
2. Then‚ we decide on the most relevant multiple(s) to use and then estimate our company’s Enterprise Value based on that (or Equity Value depending on the multiple).
3. Once we have the Enterprise Value‚ we work backwards to calculate Equity Value. We also have to account for the IPO proceeds in here (by adding them since we’re working backwards‚ these proceeds are what the company receives in cash from the IPO)
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.