Valuation Final Exam

Applying language of cap rate vs. multiple

"the building sold at a 15 cap" (15% cap rate) "the building sold at a 7x multiple" ((1+g)/(r-g) = 7)

Single multiple that converts EBITDA to value is

(1+g)/(k-g)

What is FFCF multiple

(1+g)/(r-g)

P/E ratio =

(1-b)*(1+g)/(k-g)=(1-b)*(1+br)/(k-br)

How to convert tax shield from WACC equation to actual value

1. Calculate debt value 2. Multiply debt by Kd to get interest expense 3. Multiply interest expense by tax rate to get tax shield 4. Add taxshield to initial FFCF 5. Divide by new WACC (new WACC has tax shield at 0% since already accounted for)

Gordon Growth Model requires 2 "key inputs"

1. Discount rate, k (or "r"), growth rate, g

Specific metric used as the basis for valuation can vary from applications

1. Residential real estate: $ price/sq foot; 2. Commercial real estate: $ price/NOI; 3. Corporations: $ firm enterprise value / EBITDA; 4. Stock: $ price / earnings-per-share

Steps in Relative Valuation

1: Identify similar or comparable investments & recent market prices; 2: Calculate a "valuation metric" for use in valuing the asset; 3: calculate an initial estimate of value based on means or medians from the com set; 4: refine or tailor your initial valuation estimate to the specific characteristics of the investment

Early Stage (Venture) Capital

1st, 2nd, & successive round VC financing

How does enterprise value represent PV of future CF?

2 phases; Planning period (finite number of years) & terminal period (all years after that)

Why are private equity hurdle rates so high?

25%-50%; very risky investments; low liquidity; equity firm will provide expertise as owners; hoped for CF rather than expected; opportunity costs: when money is hard to get they have many investment alternatives

Capitalization Rate formulas

=annual net operating income / cost (or value); first year cash flow / purchase price; 1/((1+g)/(k-g))

Change in NOI

=g(Revenue0/NOI0)

How is multiple obtained in practice for comparables valuation

A family of similar companies

Possible nonrecurring items

Asset write-downs; Restructuring charges; Start-up costs expensed; Profits & losses from asset sales; Change in accounting estimates or principles; Gain (loss) from discontinued operations; Strikes; LIFO liquidations; Catastrophes such as natural disasters or accidents; Product recalls

Mezzanine capital

B/T debt & equity holders; 20-40% ROR, 1-3 yrs

PE Valuation process focus

CF are insginificant early; focus on getting terminal value right!; EBITDA multiple; investor's equity>enterprise val.; deal strcuturing= negotiation of ownership stake

How does a cap rate interact with a payback period?

Cap rates are an indirect measure of how fast an investment will pay for itself. A 10% cap rate will be fully capitalized (pay for itself) after ten years (100% divided by 10%)

Second-stage capital

Commenced production but not profitable; 30-40%, 4-7 yrs

Relative valuation should be used to complement DCF analysis

DO BOTH!

Why is Hybrid EV approach beneficial?

EBITDA good b/c it ties distant CFs to recent market transactions; used in establishing EV for IPO's, LBO''s, spin-offs, carve-outs, and EqV to invest

Most popular approach to estimate firm's enterprise value

EBITDA multiples

Difference between FFCF & EBITDA

EBITDA vs. EBITDA + (- T*EBIT-CAPEX - DNWC); If the firm will not be paying taxes and will not be investing and growing experiencing any changes in working capital, FFCF = EBITDA

Dif. b/t EBITDA & P/E multiples

EBITDA: Enterprise value; P/E: equity value; Can get equity from EBITDA by removing debt

Drawbacks of P/E ratio

EPS can be negative; EPS must be recurrent, but earnings often have volatile & transient components; mgmt can "manage earnings" & distort EPS; distortion affect P/E ratios across companies

Value Owner's Equity =

Enterprise Value -(Interest bearing debt- cash)

What do PE provide besides capital?

Expertise as owners; often focus on 1 industry & have knowledge very risky investments

How would you calculate terminal value of FCF ops. & non-ops income?

FCF Ops*(1+g)/(r-g) or Non-Ops/(r-g)

1 yr calculation of value

FFCF/WACC

EBITDA Multiple Takeaway

Good valuation tool for stable, mature business where most value comes from existing assets; Less useful for evaluating growth firms

Operating leverage & cap rate across buildings

If buildings differ in their op. lev , they differ in cap rates even with same revenue & maintenance rates

APV & NPV Equivalence?

In theory, APV & NPV should give same answer; PV(unlevered CF) for Value of Assets; dif. Way to value financing decisions: NPV: tax shield in WACC wd(1-T)kd; APV: PV(Tax Shield); Need to be careful to match assumptions if we want APV=NPV

How do different rental rates affect operating leverage

Lower rental rates → more susceptible to CF changes due to changes in revenue

Building Value=

NOI* NOI multiple= (rental rev*revenue multiple) - (maintenance cost*maintain. multiple)

What is EBITDA the equivalent of?

NOI+Depriciation)

Is EBITDA multiple an intrinsic valuation?

No, but DCF is

Normalizing EBITDA multiplier for non recurring events

Onetime transaction with a customer, which contributed to EBITDA but not repeated in future years: make downward adjustment to EBITDA; Extraordinary write-offs: make an upward adjustment

What is Private Equity?

P.E. firm is financial intermediary that raises pools of capital to invest in companies that need financing; take ownership stakes in either pub. Or private comps.; ownership is restricted so stakes cannot be sold for some specific period; generally, PE investor is an active investor who acquire some measure of control over firm; investments are usually illiquid

Expansion capital

Profitable biz but can't fund via earnings; 20-30% ROR, 3-5 yrs

EBITDA & new investments

Provides good measure of before-tax CF generated by the firm's existing assets; measures only the earnings of the firm's assets already in place, it ignores the value of the firm's new investments

ROR & Years for PE funding

Rate of Return & Holding period

How is cap rate used versus a multiple

Rather than multiply by a multiple, we divide by the cap rate. In this sense, it is analogous to a discount rate

NOI =

Revenue - Fixed Costs

What does higher operating leverage lead to?

Riskier cash flows; Higher cap rates; Lower multiples on NOI or cash flows

Difficult to justify WACC assumptions

Risks of cash flows do not change over time; Company maintains a steady capital structure

Types of PE Financing

Seed capital; early stage (venture); growth capital; restructuring capital; PE firms tend to specialize in 1 of these life cycle phases

Bridge capital

Short term loan while arranging funding

Why not use a FFCF Multiple

Too volatile since it reflects discretionary expenditures for CAPEX and working capital that can change dramatically from year to year. Can also be negative

Valuation formulas (perpetuity) using cap rate for comparable buildings

Value = first year cash flow / cap rate Value = NOIt+1 / cap rate; CFt0*(1+g)/(k-g)=CFt1/(k-g)=CFt1/cap rate

When will EBITDA multiple & Gordon growth generate similar terminal value estimates?

When there is no extraordinary capital expenditures or investments in Net working capital; stable firms (i.e. FFCF more volatile than EBITDA)

Capitalization rate ("cap rate") definition

a measure of the ratio between the net operating income produced by an asset (usually real estate) and its capital cost (the original price paid to buy the asset) or alternatively its current market value.

Liquidity discounts & control premiums vary based on

bargaining position/desire of buyer/seller

As cap rate gets smaller, valuation multiple gets?

bigger. They are inverses (multiple by multiple, divide by cap rate)

How does APV approach decompose total enterprise value?

by unlevering CF, turned it into value from unlevered equity free CF & value from financing; impact of financing becomes evident

How do you use a cap rate to value building?

calculated from transactions involving comparable buildings

Cap rate & discount rate: which is higher when?

cap rate is determined by the discount rate (k) (riskiness) and the g of the CF; 1. Cap rate < k when cash flows are expected to grow (typical). 2.Cap rate > k when CF expected to decline over time (old buildings being milked as cash cows, mines and wells) 3.Cap rate = k when CF expected to stay unchanged over time.

Entrepreneurs financing

certain options can reduced required rates of return & equity stakes given to VCs in exchange for financing

Pricing IPO (discount rate+ approach)

comparables valuation analysis; 10%-25% discount of likely trading price; can subtract debt from EBITDA multiples

WACC problems

constant discount rate is inconsistent w/ projected changes to cap. Structure; LBO's; Planned M&A acitvity; Future stock buy-back plans

PV of estimate Terminal for APV

could use Gordon Growth or EBITDAx; assume cap structure is constant after PP

Implied Capitalization rate

difference b/t discount & cap rate increases w/ growth rate anticipated in future cash flows. 1/((1+g)/(k-g))

Comparables analysis should include

differences in value from distinctive features of the real estate & intangibles; Apply a "premium" or "discount" for location, size of property, view, amenities and specialty finishes, swimming pool, etc.

Unlevered CF

don't deduct interest expense CF for both creditors & equity (not actual taxes paid)

Equity analysts focus on

estimating the earnings of the firms they evaluate, and then use the price-to-earnings (P/E) ratio to evaluate the price of the common stock; P/E ratio is widely recognized and used by investors and is the most familiar valuation measure used today.

Commercial real estate valuation includes

evaluation of cash flow ratios based on building net operating income (NOI), as well as prices per sq. ft. and idiosyncratic features of the property

What drives P/E value?

firms can increase earnings by investing in positive NPV projects; Projects earn r>k; dividend growth (g) is a function of retention rate, b; g=b*r

What is operating leverage?

fixed costs

Seed Capital

friends & family & business angel; no product or service yet ; 50%-100% ROR, 10 yrs; Angels

What can cause low EBITDA

high risk AND/OR low growth opportunities relative to other firms

Multiples based on firm growth/risk

higher multiples when CF will grow faster than comparable investments, lower multiple when risk is higher

Issues to keep in mind doing comparables

identification of appropriate comps is paramount; the estimate must be tailored to the investment's specific attributes; the specific metric used as the basis for valuation can vary from one application to another

Why 20-30% liquidity discount for privately held firms?

if market-based EBITDA multiples (from public firms) were used; private comp's sell at discount to public one since shares are less liquid (harder to sell)

Operating leverage, risk, % change in revenue, rent & NOI

if rev. changes by same % for 2 buildings, higher rent (i.e. lower operating lev.) will see less % change in NOI. Less risky

Retaining earnings add value

if we can earn more than the cost of capital (r > k); i.e. P/E multiple goes up)

Value of interest tax savings for PP

interest expense*tax rate

Leveraged Buy-outs (LBOs) definition

investment strategies sued to magnify returns through use of High Debt levels

Investments with higher operating leverage will experience

more volatility in operating income in response to changes in revenues

How to account for differences in risk

must assess potential impact of differences on the valuation multiples. Impact and increased risk of operating leverage (= FIXED costs) can be very important

Selecting valuation ratio

numerator & denominator should both be based on equity or entire set of firm assets i.e. Price/Share / Earnings/Share, not Price/Share / EBITDA

Growth Capital

often including consolidation financing & exit financing for founders

Terminal value in Enterprise value

often represents more than 50% of EV; perpetuity approach (gordon growth model) Multiples approach (EBITDA multiples)

First Stage capital

proven product; need marketing & production; 40-60% ROR, 5-10 yrs; VC's 1st entry point

Financial v. Strategic Buyer (What price buyer pay for a company?)

purely financial buyer: expect liquidity discount for acquisition of private firm (20-30% discount); strategic buyer: realize synergies by acquiring & controlling investment, >30% premium

Why use EBITDA as a proxy for cash flow?

relatively simple to obtain; just need to use the accompanying multiple

**2 things that make growht

retention rate; projects returns that are more than shareholders are expecting; need promise of future growth

Why Adjusted Present Value approach?

reveals how company's financing decisions influence enterprise value

Selecting comparable firms

same industry; should match on growth & risk (i.e. operating costs & capital structure);

Key assumption with market comps

similar assets should sell at similar prices: Law of "One Price"; the "comparable" assets transactions are truly comparable to the investment being evaluated (risk & growth)

Link between DCF & Comps

standard DCF approaches like Gordon Growth Model: g and k are separately specified as inputs to the equation; Comps: a composite single multiple incorporates and includes both pieces of information (k and g) in one number

Enterprise value definition

sum of the firm's interest-bearing debt and its equity minus the firm's cash balance on the date of the valuation.

Most widely used valuation metric in commercial real estate

the "cap rate" (capitalization rate)

Why are "Capitalization rates" used?

to turn a recurring cash flow amount (NOI, EBITDA, earnings-per-share EPS, ATCF, etc.) into a lump sum value

Terminal value & length of planning period

typical planning period=5 years; % of EV that comes from TV decreases as length of planning period (n) ^

Unlever equity FCF for PP

use unlevered CoC instead of WACC

Venture capital definition

value "hoped-for" CFs by implementing high discount rates to account for high risk & illiquidity of these investments

Value of the interest tax savings accounts for?

value of all side effects of financing decisions; debt financing provides tax benefit b/c interest tax deduction realized by firm

Private equity definition

vital source of capital for start-ups as well as more operationally mature firms

Restructuring capital

vulture capital; LBOs