Valuation Questions

Let's say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $15 each - what is its fully diluted equity value?

$1,000. In this case the options' exercise price is above the current share price, so they have no dilutive effect.

DCF formula

* Value = ∑𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤/(1+𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒)^t

Should Cost of Equity be higher for a $5 billion or $500 million market cap company?

- $500 million company, because all else being equal, smaller companies are expected to outperform large companies in the stock market (and therefore be "more risky"). -Using a Size Premium in your calculation would also ensure that Cost of Equity is higher for the $500 million company.

Why is calculating beta risky

- Calculating raw betas from historical returns and even projected betas is an imprecise measurement of future beta because of estimation errors (i.e. standard errors create a large potential range for beta).

Walk me through an LBO

- Make purchase price assumptions on purchase price, debt repayment, and -Create sources to determine how the transaction will be financed and the capital uses -Find EBITDA and cash flow available for debt repayment over the investment horizon (typically 3 to 7 years). -Determine how much debt is repaid each year -Adjust balance sheet for new debt and equity -Estimate the multiple at which the sponsor is expected to exit the investment (should generally be similar to the entry multiple). -use the multiple to calculate exit value and subtract net debt for equity value -Calculate equity returns (IRRs) using excel with range of dates and range of equity values) -Solve for the price that can be paid to meet the above parameters (alternatively, if the price is fixed, solve for achievable returns).

Why do you subtract cash in the formula for Enterprise Value? Is that always accurate?

- The "official" reason: Cash is subtracted because it's considered a non-operating asset and because Equity Value implicitly accounts for it. The way I think about it: In an acquisition, the buyer would "get" the cash of the seller, so it effectively pays less for the company based on how large its cash balance is. Remember, Enterprise Value tells us how much you'd really have to "pay" to acquire another company. It's not always accurate because technically you should be subtracting only excess cash - the amount of cash a company has above the minimum cash it requires to operate.

Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?

-"Does management think the tooth fairy pays for capital expenditures?" - Because EBITDA excludes the often sizable Capital Expenditures - Hides how much cash they are actually using to finance their operations. -Some industries there is also a large gap between EBIT and EBITDA

Intrinsic (Con)

-Access to information required to make cash flow projections and discount rate assumptions is limited, particularly for non-publicly traded businesses. -Highly sensitive to discount rates and cash flow assumptions.

When would you use a Liquidation Valuation?

-Bankruptcy scenarios- used to see whether equity shareholders will receive any capital after the company's debts have been paid off. -Used to advise struggling businesses on whether it's better to sell off assets separately or to try and sell the entire company.

6. Let's say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $5 each - what is its fully diluted equity value?

-Basic equity value is $1,000 (100 * $10 = $1,000). -When these options are exercised, there will be 10 new shares created - so the share count is now 110 rather than 100. -To exercise the options, we had to "pay" the company $5 for each option (the exercise price). -Now has $50 in additional cash, which it now uses to buy back 5 of the new shares we created. -Fully diluted share count is 105, and the fully diluted equity value is $1,050.

Why would two companies in the same sector trade at different EBITDA multiples

-Different margin profiles/cash flow conversion -different market share/competitive dynamics (one could be larger. geoographic, product

Relative (Pro)

-Easy to calculate - requires fewer explicit assumptions than intrinsic valuation.

Correlation between cost of equity and risk

-Expected return correlated with risk -the cost of equity represents the required rate of return an equity investor applies to expected equity cash flows to determine how much should be paid for those cash flows. -A higher perceived risk by the investor will require a greater return.

When would a Liquidation Valuation produce the highest value?

-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). - Then the company's Comparable Companies and Precedent Transactions would likely produce lower values as well - and if its assets were valued highly enough,

P/E valuation

-If 2 companies are relatively the same in terms of capital structure, size, etc/ then you would choose the stock with the lower P/E as you we be paying less per dollar of earnings

. How do you know if your DCF is too dependent on future assumptions?

-If significantly more than 50% of the company's Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions. -In reality, almost all DCFs are "too dependent on future assumptions"

When would you not use a DCF in a Valuation?

-If the company has unstable or unpredictable cash flows (tech or bio-tech startup) -If debt and working capital serve a fundamentally different role (ex. banks and financial institutions do not re-invest debt and working capital)

How would you determine how much debt can be raised in an LBO and how many tranches there would be?

-Look at Comparable LBOs and see the terms of the debt and how many tranches each of them used. -Look at companies in a similar size range and industry and use those criteria to determine the debt your company can raise.

Working Capital

-Measure of efficiency and short-term health -Current Assets-Current Liabilities

Explain Relative valuation

-Multiples: Determine a comparable peer group -Find companies that are in the same industry with similar operational, growth, risk, and return on capital characteristics. -Problem: Truly identical companies of course do not exist, but you should attempt to find as close to comparable companies as possible. -Calculate appropriate industry multiples→ Apply the median of these multiples on the relevant operating metric of the target company to arrive at a valuation.

Profit Margin

-Net income/revenue -very useful when comparing companies in similar industries. -A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. -displayed as a percentage; a 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.

Why would a PE firm choose to do a dividend recap of one of its portfolio companies?

-Primarily to boost returns. -All else being equal, more leverage means a higher return to the firm. - With a dividend recap, the PE firm is "recovering" some of its equity investment in the company -The lower the equity investment, the better, since it's easier to earn a higher return on a smaller amount of capital.

Beta

-Provides a method to estimate the degree of an asset's systematic (non-diversifiable) risk. -Beta equals the covariance between expected returns on the asset and on the stock market, divided by the variance of expected returns on the stock market. arket.

Why use p/e ratio for Trading Comps

-Reflects change in capital structure -maybe the two things you aren't comparing aren't similar -most recognized -doesn't matter for companies w/ little or no earnings -high p/e-->high growth expectations

Market risk premium

-Represents the actual additional risk of investing in stocks (rm-rf) over the risk free rate. -Practitioners often use the historical excess returns method, and compare historical spreads between S&P 500 returns and the yield on 10 year treasury bonds. -Ibbotson guide used to estimate MRP -firmwide policy to insure consistency

Why is this a science and an art

-Science: there are formulas and math and theories behind all of these calculations. You use facts from balance sheets and other market analysts to form a logical conclusion -Art: These are only projections. Requires judgment on the part of the modeler. They aren't exact and with knowledge of the industry you get better at coming closer to these projections -Art: Which methodology to apply, how to determine LTGR do these numbers look right, building up intuition about understanding valuation methods

Good LBO candidate

-Srong, predictable operating cash flows with which the leveraged company can service and pay down acquisition debt -Well-established business and products and leading industry position -Moderate CapEx and product development (R&D) requirements so that cash flows are not diverted from the principle goal of debt repayment -Limited working capital requirements -Undervalued or out-of-favor -Strong management team -Viable exit strategy

Why delever and re lever beta?

-Stocks of companies that have debt are more risky, therefore we must strip out debt (unlever) from beta in order to arrive at a universal value. -After unlevering beta you may use the appropriate "industry" beta for comparison and relever it for the appropriate capital structure of the company being valued

What is a dividend recapitalization ("dividend recap")?

-The company takes on new debt solely to pay a special dividend out to the PE firm that bought it. -Metaphor: you make your friend take out a personal loan just so he/she could pay you a lump sum of cash with the loan proceeds. -Dividend recaps have developed a bad reputation, though they're still commonly used.

Intrinsic (Pro)

-Theoretically sound: the value of an asset should fundamentally equal the present value of the cash that this asset can generate. -Provides framework for judging market valuations. Does not necessarily shed light on what a seller can expect to receive for an asset in the market (and vice versa). -DCF- operating strat is included in the model.

Why are Goodwill & Intangibles created in an LBO?

-These both represent the premium paid to the "fair market value" of the company. -In an LBO, they act as a "plug" and ensure that the changes to the Liabilities & Equity side are balanced by changes to the Assets side.

Why would you use leverage when buying a company?

-To boost your return. -Any debt you use in an LBO is not "your money" - so it's easier to earn a high return on $2 billion of your own money and $3 billion borrowed from elsewhere vs. $3 billion of your own money and $2 billion of borrowed money. -A secondary benefit is that the firm also has more capital available to purchase other companies because they've used leverage.

Talk about Exit multiple method generally

-Usually use (EV/EBITDA, EV/EBIT, etc.) to the relevant statistic projected for the last projected year. -Since the DCF values cash flow available to all providers of capital, use EV multiples not equity value multiples. -usually developed based on selected companies' trading multiples. being applied to the statistic projected for the last projection year,

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

-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. -To get the "football field" - find minimum, maximum, 25th percentile and 75th percentile in each set as well and create a range of values based on each methodology.

How do you think about valuation across time for a cyclical company?

-Valuation at the peak of the cycle usually commands a high multiple on elevated earnings. -Valuation at the trough of the cycle can be a depressed multiple based on depressed earnings.

Why EV/EBITDA Trading Comps

-Valuation standard in most sectors -Independent of cap structure and taxes -Independent of differences in d&a

Cons to LBO

-Value obtained is sensitive to projections and how aggressive assumptions were -underestimate the sale value b/c it ignores synergies -Sponsors/financial buyers pay smaller premium than strategic b/c they're in it for a shorter period

High level: explain LBO (leveraged buyout) analyses

-Value to a financial sponsor -Value based on debt repayment or return on investment -provides a "floor" valuation for the company, and is useful in determining what a financial sponsor can afford to pay for the target and still realize an adequate return on its investment.

What is the appropriate discount rate to use in an unlevered DCF analysis?

-WACC

Why do you need to add Minority Interest to Enterprise Value?

-Whenever a company owns over 50% of another company, it is required to report the financial performance of the other company as part of its own performance. -So even though it doesn't own 100%, it reports 100% of the majority-owned subsidiary's financial performance. -In keeping with the "apples-to-apples" theme, you must add Minority Interest to get to Enterprise Value so that your numerator and denominator both reflect 100% of the majority-owned subsidiary.

Risk free rate

-Yield of "risk-free" "default-free" government bonds of equivalent maturity. - Current yield on 10-year U.S. Treasury bonds is the preferred proxy

How do you select the appropriate exit multiple when calculating Terminal Value?

-You look at the Comparable Companies and pick the median of the set, or something close to it. -Show a range of exit multiples and what the Terminal Value looks like over that range rather than picking one specific number. -Ex: median EBITDA multiple of the set were 8x, you might show a range of values using multiples from 6x to 10x.

Transaction comp pros

-analysis based on actual acquisition multiples and premiums -recent transaction reflect prevailin M&A and cap market conditions -Trends duchas foreign purchases or financial buyers may become clear

Talk about Perpetuity Growth generally

-assumes that the company will continue its historic business and generate FCFs at a steady state forever -The perpetuity growth rate is typically between the historical inflation rate of 2-3% and the historical GDP growth rate of 4-5%. -not used often b/c it's hard to estimate the perpetuity growth rate and determine when the company achieves steady-state. -can be used to check exit multiple

Trading Comp Pros

-based on few easy to calculate inputs -based on key factors to investors -market efficiency ensures trading values reflect industry trends, business risk, and market growth

market value of debt

-book value as proxy for market value -use market value if credit rating of issuer or risk free rate has changed substantially

High level: explain what an LBO deal is

-buyer invests a small amount of equity and uses leverage (debt or other non-equity sources of financing) to acquire a company

Pros to LBO analysis

-good for finding LBO opportunities -highlights effects of adding leverage to business -shows what value any financial bidder will have to exceed -estimates potential equity returns to the business, provides sensitivity of returns

Why EV/Revenue Trading Comps

-good for no revenue -sanity check for EV/EBITDA -Con: not as relevant since cashflow and profitability not accounted fo

Questions that valuations answer

-how much debt can we take on -how much should we pay to buy the assets/company -how much can we sell the company/division for -how much can we sell our company for on th public market

What is the Capital asset pricing model

-links the expected return of a security to its sensitivity the overall market baket (often proxied using the S&P 500). -divided in systematic and unsystematic risk. -systematic (market) risk can be divided out -We use it because we can't expect to know how much each investor wants to make

define terminal value

-long-term valuation of the company's growth approaches -Assumes that the business will be valued at the end of the projection period, based on public markets valuations

transaction comp cons

-may not reflect current market conditions -each transaction uq--> we don't know all the factors that when into it -wide range of multiples, be careful -may be comparing apples to organges

Other than for a leveraged buyout, when do you use an LBO Analysis as part of your Valuation?

-set a "floor" on a possible Valuation for the company you're looking at -used to establish how much a private equity firm could pay, which is usually lower than what companies will pay.

What does it mean when a company yields returns of 11% and has a WACC of 17%?

-the company is losing six cents for every dollar spent -may not be a very good investment

What is WACC

-the minimum acceptable rate of return at which a company yields returns for its investors - Value of a business is the sum of all the cash flows it will generate, discounted to the present value using a discount rate that reflects the riskiness of the business. -reflects the riskiness of a private or publicly traded company for providers of capital, including debt and equity holders. -For this reason, the numerator in the equation represents free cash flows before any interest or debt payments, aka unlevered free cash flows.

Trading Comp Cons

-under/overvalue if markets are really high or low -assume the markets have correctly valued the company -not comparing apples to apples

What are the two types of relative valuation

1. Compare similar transactions 2. compare similar companies

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

1. it excludes net debt 2. Equity Value / EBITDA is comparing apples to oranges because Equity Value does not reflect the company's entire capital structure - only the part available to equity investors. 3.EBITDA is available to all investors in the company - rather than just equity holders. Enterprise Value is also available to all shareholders so it makes sense to pair them together.

walk me through Trading comp

1. select comparable companies 2. Determine enterprise value of each 3. Decide on a multiple that would provide the best model (EV/Sales, EV/EBITDA, P/E) 4. Find the multiple for all of the comparable companies 5. Take median/avg multiple 6. multiply by EBITDA to find enterprise value

What is the difference between bank debt and high-yield debt?

High Yield Debt: • Higher interest rates • Interest rates are usually fixed • Has incurrence covenants • Entire principal is due at the end (bullet maturity) Bank Debt: • Interest rates are "floating" - they change based on LIBOR or the Fed interest rate. • Has maintenance covenants • Bank debt is usually amortized - the principal must be paid off over time Usually in a sizable Leveraged Buyout, the PE firm uses both types of debt.

When should you value a company using a revenue multiple vs. EBITDA?

Companies with negative profits and EBITDA will have meaningless EBITDA multiples. As a result, Revenue multiples are more insightful.

Trading Comps 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

Two companies are exactly the same, but one has debt and one does not - which one will have the higher WACC?

All else being equal, the one without debt will have a higher WACC, because debt is "less expensive" than equity: • Interest on debt is tax-deductible • Debt holders paid first in a liquidation or bankruptcy. • Interest rates on debt are usually lower than the Cost of Equity numbers you see (usually over 10%). As a result, the Cost of Debt portion of WACC will contribute less to the total figure than the Cost of Equity portion will.

Which method for calculating terminal value is more common? Why

Almost always use the Multiples Method to calculate Terminal Value in a DCF. --> easier to get exit multiples based on Comparable Companies - than to pick a long-term growth rate, by contrast, is always a shot in the dark.

What are the two types of intrinsic valuation

Discounted Cash Flow (more respected in academia and more commonly used in IB) and Leveraged Buyout

Unlevered free cash flow

EBIT * (1-TAX RATE)+ D&A+non-cash items + net working capital chanages- CAPEX

When looking at an acquisition of a company, do you pay more attention to Enterprise or Equity Value?

Enterprise Value, because that's how much an acquirer really "pays" and includes the often mandatory debt repayment.

Why do we look at both Enterprise Value and Equity Value?

Enterprise Value- value of the company that is attributable to all investors; Equity Value- represents the portion available to shareholders (equity investors). You look at both because Equity Value is the number the public-at-large sees, while Enterprise Value represents its true value.

Equity value (long version)

Eq. Value= Enterprise Value + Long Term Investments + Cash - Debt- Minority Interest - Preferred Stock

Enterprise value (long version)

Equity Value + Debt + Preferred Stock + Minority Interest - Cash

What is enterprise value

Equity Value + Net Debt Equity Value+ (Debt- cash & cash equivalents) Value of all operating assets: Operating assets - operating liabilities Represents value available to common shareholders

Enterprise Value vs Equity Value

Equity value is= Enterprise value - debt

Purpose of DCF

Estimate the money an investor would receive from an investment, adjusted for the time value of money.

Terminal value formula-- Perpetuity Growth

FCF* (1 + long-term growth rate) / (WACC- long-term growth rate)

How do you calculate fully diluted shares?

Basic share count + dilutive effect of stock options + any other dilutive securities (warrants, convertible debt or convertible preferred stock)

Interepret Beta

Beta of 1: Expected return on stock = return on market portfolio Beta < 1: Expected return on stock < return on market portfolio Beta > 1: Expected return on stock > return on market portfolio Diverse company, conglomerates: beta of 1 Beta of > 1: Tiffany's, super cyclical Beta of < 1: Utility companies, we always need it

Discounting

Cash Flow/(1+r)^t

Levered vs unlevered dcf

Levered DCF uses the cost of equity, unlevered uses the WACC which incorporates costs of capital to debt and equity investors.

Let's say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF - what is the effect?

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the cash flow is only available to equity investors (debt investors have already been "paid" with the interest payments).

How would you value an apple tree?

Looking at what comparable apple trees are worth (relative valuation) Look at the value of the apple tree's cash flows (intrinsic valuation).

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

May use equity value if company has negative Enterprise Values If you've listed a set of financial and non-financial companies on a slide, you're showing Revenue multiples for the non-financial companies, and you want to show something similar for the financials. Note: in most cases you would be using other multiples such as P/E and P/BV with banks anyway.

What does it mean when a company yields returns of 20% and has a WACC of 11%?

Means the company is yielding 9% returns on every dollar the company invests. In other words, for each dollar spent, the company is creating nine cents of value.

Which method of calculating Terminal Value will give you a higher valuation?

Multiples Method- more variable than the Gordon Growth method because exit multiples tend to span a wider range than possible long-term growth rates.

calculate EPS

Net Income/Shares outstanding

Is it always accurate to add Debt to Equity Value when calculating Enterprise Value?

Never say never, there are exceptions but usually, here's why: -The terms of a debt agreement usually say that debt must be refinanced in an acquisition. - Usually a buyer will pay off a seller's debt, so it is accurate to say that any debt "adds" to the purchase price. - Exception: the buyer does not pay off the debt-->rare

Could a company have a negative Equity Value? What would that mean?

No. This is not possible because you cannot have a negative share count and you cannot have a negative share price.

How do you get from revenue to FCF

Operating Income= Revenue- COGS- Operating expenses Free cash flows = Operating profit (EBIT) * (1 -tax rate) + depreciation & amortization - changes in net working capital - capital expenditure

What other Valuation methodologies are there?

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 • Sum of the Parts - Valuing each division of a company separately and adding them together at the end • LBO Analysis - Determining how much a PE firm could pay for a company to hit a "target" IRR, usually in the 20-25% range

Explain diluted shares outstanding

Outstanding Actual share count (basic shares) + dilutive securites( shares that aren't quite common stock but can be converted) Outstanding Actual share count (basic shares) + stock options+convertible debt+ convertible preferred stock+ warrants +restricted stock units+ performance units

Transaction Comps examples

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

Why do we add Preferred Stock to get to Enterprise Value?

Preferred Stock pays out a fixed dividend, and preferred stock holders also have a higher claim to a company's assets than equity investors do. As a result, it is seen as more similar to debt than common stock.

Problems with relative

Problem: company might not be similar structure, and a variety of factors may explain why a similar company had a specific value at any point in time Ex: pharmaceutical w/ expiring patent, before or after 2008, etc.

Pro forma

Projected

What's an appropriate growth rate to use when calculating the Terminal Value?

Something conservative: country's long-term GDP growth rate, the rate of inflation, or something similarly conservative.

18. How do you select Comparable Companies / Transactions?

The 3 main ways to select companies and transactions: 1. Industry classification 2. Financial criteria (Revenue, EBITDA, etc.) 3. Geography Precedent Transactions: -limit to past 1-2 years. - focus on industry

High level: explain intrinsic

The value of a business equals the sum of all the cash flows it will generate, discounted to the present value using a discount rate that reflects the riskiness of the business.

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

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 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.

What about WACC - will it be higher for a $5 billion or $500 million company?

Trick question- depends on whether the capital structure is the same for both companies. If the capital structure is the same (in terms of percentages and interest rates and such) then WACC should be higher for the $500 million company because small companies=riskier If the capital structure is not the same, either way depending on how much debt/preferred stock each one has and what the interest rates are.

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

Trick question. Unlevered Free Cash Flow: Enterprise Value Levered Free Cash Flow: Equity Value

What do we use as the discount rate for unlevered

weighted average cost of capital (WACC) as the discount rate.

Name and explain 3 things a P/E firm might specialize in

• Industry consolidation - buying competitors in a similar market and combining them to increase efficiency and win more customers. • Turnarounds - taking struggling companies and making them function properly again. • Divestitures - selling off divisions of a company or taking a division and turning it into a strong stand-alone entity.

Assumptions of DCF (what does it say about a productive asset)

• The value of a productive asset equals the present value of its cash flows. • Answer should run along the line of "project free cash flows for 5-7 years, depending on the availability and reliability of information

How do you derive beta

• Use industry beta then unlever it, then relever to companies capital structure • Betas of comparable companies are distorted because of different rates of leverage • β Unlevered = β(Levered) / [1+ (Debt/Equity) (1-T)] • Then, once an average unlevered beta is calculated, relever this beta at the target company's capital structure: • β Relevered = β(Unlevered) x [1+(Debt/Equity) (1-T)]

Relative (Con)

• When deriving value by comparing to other companies, you are never really comparing apples-to-apples. • Sometimes there are no peers, and comparison cannot be performed.

When is acquisition Accretive/Dilutive

•An acquisition is accretive when the combined projected (pro forma) EPS is greater than the acquirer's standalone EPS.

Why would you not use a DCF for a bank or other financial institution? (two reasons)

Two reasons: 1. Banks use debt differently than other companies and do not re-invest it in the business - they use it to create products instead. 2. Interest is a critical part of banks' business models and working capital takes up a huge part of their Balance Sheets - so a DCF for a financial institution would not make much sense. More common to use a dividend discount model for valuation purposes

unlevered vs. levered cash flows

Unlevered Free Cash Flow excludes Interest and thus represents money available to all shareholders Levered already includes Interest and the money is therefore only available to equity shareholders. Debt investors have already "been paid" with the interest payments they received.

Best valuation for majority stake

We are trying to achieve control of board and company Transaction Comparables DCF (with synergies, assumes control) LBO

Best valuation for minority stake

We're not trying to value control Trading Comparables DCF (without synergies)

When would you use Sum of the Parts?

When a company has completely different, unrelated divisions (Conglomerate) ex: GE --> if company has 6 diff divisions, value each one separately, and then add them together to get the Combined Value.

Do you need to project all 3 statements in an LBO model? Are there any "shortcuts?"

Yes, there are shortcuts and you don't necessarily need to project all 3 statements. Balance Sheet: For example, you do not need to create a full Balance Sheet - bankers sometimes skip this if they are in a rush. --You can just make assumptions on the Net Change in Working Capital rather than looking at each item individually. Income Statement: You do need some form of Income Statement, something to track how the Debt balances change and some type of Cash Flow Statement: how much cash is available to repay debt.

WACC formula

[ Rd(1-CTR) debt/(debt +equity)] + [Re*equity/debt+equity]

how do you find out net new shares to stock options

[(number of options)*(market price - strike)]/market price

transaction comp description

based on previous M&A deals higher multiple because of market premium

Enterprise Value (short version)

fair equity value + net debt

walk me through transaction comps

higher multiples 1. Determine universe of comparable transactions 2. Calculate multiples on LTM basis 3.Apply the calculated mean/median to target's corresponding operating metrics to arrive at a value

LTGR

long term growth rate

how do you find cost of debt

look it up on bloomberg or moody's or something

How do you calculate market price of equity

market cap= shares outstanding * stock price

What does it mean if someone models perpetuity growth as greater than 5%

that you expect the company's growth to outpace the economy's growth forever.

Walk me through how to do a DCF valuation (over specific)

1. Estimate future cash flow- determining the company's trailing twelve month (ttm) free cash flow (FCF), equal to that period's operating cash flow minus capital expenditures. -----Say that Company X's ttm FCF is $50 m. We would compare this figure to previous years' cash flows in order to estimate a rate of growth. ------Consider source of this growth. Are sales increasing? Are costs declining? 2. Say that you estimate that Company X's cash flow will grow by 10% in the first two years, then 5% in the following three. After a few years, you may apply a long-term cash flow growth rate, representing an assumption of annual growth from that point on. This value should probably not exceed the long-term growth prospects of the overall economy by too much; we will say that Company X's is 3%. 3. Calculate a WACC 4. Use WACC and Terminal Value formula to calculate Terminal value an present value of FCF 5. Use the terminal value and WACC and DCF formula to estimate enterprise value 6. Once you have enterprise value, subtract debt (money beholden to bondholder's) to get fair equity value 7. Divide equity value by number of shares outstanding for fair equity value per share 8. Compare our estimate to current stock price. If ours is higher, we might consider Company X a good investment.

Why would a private equity firm buy a company in a "risky" industry, such as technology?

1. It's fine-- There are mature, cash flow-stable companies in almost every industry. 2. Some PE firms specialize in very specific goals so even if a company isn't doing well or seems risky, the firm might buy it if it falls into one of these specialties.

Can you explain how the Balance Sheet is adjusted in an LBO model?

1. Liabilities adjusted - the new debt is added on. 2. Shareholders' Equity is "wiped out" and replaced by however much equity the private equity firm is contributing. 3. Assets side, Cash is adjusted for any cash used to finance the transaction, and then Goodwill & Intangibles are used to make the Balance Sheet balance. Depending on the transaction, there could be other effects as well - such as capitalized financing fees added to the Assets side.

How could a private equity firm boost its return in an LBO?

1. Lower the Purchase Price in the model. 2. Raise the Exit Multiple / Exit Price. 3. Increase the Leverage (debt) used. 4. Increase the company's growth rate (organically or via acquisitions). 5. Increase margins by reducing expenses (cutting employees, consolidating buildings, etc.). All "theoretical" and refer to the model not reality

two ways to calculate terminal value

1. Perpetuity growth= FCF* (1 + long-term growth rate) / (WACC- long-term growth rate) --grow at 2-4% not exceed growth of economy --assumes FCF in last year grows at a constant rate indefinitely 2. Exit multiple method= Multiple * Financial Metric --Assumes company is worth a multiple of an operating method --Use company LTM multiple, or the one of trading comps --should reflect steady state growth and margins

What variables impact an LBO model the most?

1. Purchase and exit multiples have the biggest impact on the returns of a model. 2. The amount of leverage (debt) used also has a significant impact 3. Operational characteristics- revenue growth and EBITDA margins.

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

1. Substantial mismatch between the M&A market and the public market. 2. For example, if no public companies have been acquired recently but there have been a lot of small private companies acquired at extremely low valuations.

We saw that a strategic acquirer will usually prefer to pay for another company in cash - if that's the case, why would a PE firm want to use debt in an LBO?

1. The PE firm does not intend to hold the company for the long-term - it usually sells it after a few years, so it is less concerned with the "expense" of cash vs. debt and more concerned about using leverage to boost its returns by reducing the amount of capital it has to contribute upfront. 2. In an LBO, the debt is "owned" by the company, so they assume much of the risk. In a strategic acquisition, the buyer "owns" the debt so it is more risky for them.

Why might you use bank debt rather than high-yield debt in an LBO?

1. The buyer is concerned about meeting interest payments and wants a lower-cost option, 2. They are planning on major expansion or Capital Expenditures and don't want to be restricted by incurrence covenants.

Why would a PE firm prefer high-yield debt instead?

1. They intend to refinance the company soon 2. They don't believe their returns are too sensitive to interest payments 3. They don't have plans for major expansion or selling off the company's assets.

Why would you use Gordon Growth rather than the Multiples Method to calculate the Terminal Value?

1. You have no good Comparable Companies 2. You have reason to believe that multiples will change significantly in the industry several years down the road. --->Ex: if an industry is very cyclical you might be better off using long-term growth rates rather than exit multiples.

Walk me through DCF- Broad

Assuming unlevered: 1. Determine free cash flow (FCF), equal to that period's operating cash flow minus capital ex . 2. Calculate a WACC using cost/market value of debt and equity 3. Do over period of 5-7 years, find each FCF and discount by the WACC, and add them all plus the terminal value 4. Calculate Terminal value either using the multiples method or growth in perpetuity method. 5. Add all that up to find enterprise value 6. Once you have enterprise value, subtract debt to get fair equity value 7. Divide equity value by number of shares outstanding for fair equity value per share 8. Compare our estimate to current stock price. If ours is higher, we might consider Company X a good investment.

What are the two ways to value a company?

Intrinsic and Relative (two within each Transaction Comparables, Trading Comparables, DCF , LBO)

How would a dividend recap impact the 3 financial statements in an LBO?

Income Statement: no changes Balance Sheet: Debt would go up and Shareholders' Equity would go down Cash Flow Statement: under Financing the additional Debt raised would cancel out the Cash paid out to the investors, so Net Change in Cash would not change. -->no changes to Cash Flow from Operations or Investing

Maintenance vs incurrence covenant

Incurrence covenants- prevent you from doing something (such as selling an asset, buying a factory, etc.) Maintenance covenants- require you to maintain a minimum financial performance (for example, the Debt/EBITDA ratio must be below 5x at all times).

Explain EV/EBITDA multiple

Independent of capital structure, wheras P/E ratio is sometimes misleading as it is largely dependent on capital structure. Large amounts of debt or equity can either make multiples appera inflated or deflated

Common valuation multiples in comps analysis to focus on

Revenue -EV/EBITDA -EV/Revenue -EV/EBIT Equity Value Multipls: -P/E -Market Cap/ Net Income -P/E to Growth (PEG Ratio)

Terminal value formula-- Exit Multiple method

TV = LTM Terminal Multiple × Statistic projected for the last 12 months of the projection period

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

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.

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

Trick question - there is no ranking that always holds. In general, 1. DCF often higher, but may not be, depending on assumptions 2. Comparable Transactions will be higher than Comparable Companies due to the Control Premium built into acquisitions. 3. Comparable companies may be higher or lower depending on the economic conditions

How to calculate equity

Three ways: 1. Fama-French 3 factor model 2. Arbitrary pricing theory (APT) 3.Use CAPM: Cost of equity (re) = Risk free rate (rf) + β x Market risk premium (rm-rf )

How do you calculate the dilutive effect of options

Treasury Stock Method

Could a company have a negative Enterprise Value? What would that mean?

Yes. Either an extremely large cash balance, or an extremely low market capitalization (or both). You see it with: 1. Companies on the brink of bankruptcy. 2. Financial institutions, such as banks, that have large cash balances.

What should you do if you don't believe management's projections for a DCF model?

You can take a few different approaches: • Create your own projections. • Modify management's projections downward to make them more conservative. • Show a sensitivity table based on different growth rates and margins and show the values assuming managements' projections and assuming a more conservative set of numbers. You'd probably do all of these