Valuation
What are some ways you can value a company? What are the two fundamanetal ways to value a company?
-- Comparable Companies/Multiple Analysis -- Precedent Transactions -- DCF -- LBO Two fundamental ways to value a company are intrinsic valuation and relative valuation. DCF is intrinsic and comps, precedent transactions, and LBO is
why would a company with similar growth and profitability to comps be valued at a premium
1. recently reported earnings above expectations. stocks rise 2. competitive advantage not reflected in financials 3. market leader
How to calculate EBIT
EBIT is just a company's Operating Income on its Income Statement; it includes not only COGS and Operating Expenses, but also non-cash charges such as Depreciation & Amortization and therefore reflects, at least indirectly, the company's Capital Expenditures
How to calculate EBITDA
EBITDA is defined as EBIT plus Depreciation plus Amortization. You may sometimes add back other expenses as well
What does the end value of the DCF give you?
Enterprise value.
How do you get to free cash flows from (revenue/operating cash flows/net income)?
From revenues: revenues minus cost of goods sold gives you gross profit, minus supplies, general & administrative, and depreciation and amortization gives you EBIT. Tax affect EBIT to give you Earnings Before Interest After Taxes, then add back depreciation & amortization, subtract out changes in working capital and capital expenditures to get (unlevered) FCF. From operating cash flows: subtract capital expenditures, From net income: Add back interest, tax affect it, add back depreciation & amortization, subtract changes in working capital and cappex.
How do I calculate enterprise value?
Fully diluted equity (in the money options, warrants, convertible debt) + net debt + minority interests.
What is goodwill and how does it affect net income?
Goodwill is an intangible asset found on a company's balance sheet. Goodwill may include things like intellectual property rights, a brand name, etc. Usually goodwill is acquired when purchasing a firm, in that the acquirer pays a higher amount for the firm than the book value of its assets. If an event occurs that diminishes the value of these intangible assets, the assets must be "written down" in a process much like depreciation. Goodwill is then subtracted as a non-cash expense and therefore reduces net income.
Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?
He dislikes EBITDA because it hides the Capital Expenditures companies make and disguises how much cash they require to finance their operations. In some industries there is also a large gap between EBIT and EBITDA - anything that is capital-intensive and asset-heavy, for example, will show a big disparity.
How would you calculate the discount rate for an all equity firm?
If a firm is all equity, then you would use CAPM to calculate the cost of equity, and that would be the discount rate.
How would you value a company with no revenue?
In order to value a company with no revenue, such as a start up, you must project the company's cash flows for future years and then construct a discounted cash flow model of those cash flows using an appropriate discount rate. Alternatively, you could use other operating metrics to value the company as well. If you took a start-up website with 50,000 subscribers, but no revenue, you could look at a similar website's value per subscriber and apply that multiple to the website you are valuing.
Who has first rights to assets if a company becomes bankrupted?
In the event of bankruptcy, the common stockholders will have the last right to assets in the event of liquidation, and therefore are bearing the highest level of risk. Due to this they will demand the highest return on their investment. Those shareholders are the owners of the company and have the rights to the firm's profits, which may be paid out in the form of dividends or reinvested back into the business.
What is IRR?
Internal rate of return; what discount rate is required to make the net present value of all cash uses/sources equal to 0
Let's say a company has had great free cash flow for the past 100 years and it declares bankruptcy. Why would this happen?
It probably has taken on a lot of debt and can
Why are Public Comps and Precedent Transactions sometimes viewed as being "more reliable" than a DCF?
It's because they're based on actual market data, as opposed to assumptions far into the future. Note, however, that you still do make future assumptions even with these (for example, the "Forward Year 1" and "Forward Year 2" multiples in the graphs above are based on projections for each company in the set).
How do I lever beta?
Levered Beta = Unlevered Beta x (1 + (Debt / Equity) x (1 - tax rate))
How to calculate LFCF?
Levered FCF = Net Income + Non-Cash Charges - Change in Operating Assets and Liabilities - CapEx - Mandatory Repayments With Levered FCF, you're including interest income, interest expense, and required principal repayments on the debt.
If I issue debt for $100, what happens to EV?
No change, debt increase of $100 is canceled out by a cash increase of $100.
What are the flaws with Public Company Comparables?
No company is 100% comparable to another company. • The stock market is "emotional" - your multiples might be dramatically higher or lower on certain dates depending on the market's movements. • Share prices for small companies with thinly-traded stocks may not reflect their full value.
Can you use private companies as part of your valuation
Only in context of precedent transactions have no values for market cap or beta
How much would you pay for a company with $50 million in revenue and $5 million in profit?
Since you have no information about historical or projected performance, as well as no details about the firm's capital structure, it would be impossible to do a DCF analysis. Assuming you know the firm's industry, and can identify a group of comparable companies, your best bet would be to do a multiples analysis using the ratios from those comparable companies that are most relevant to the given industry.
What happens to Free Cash Flow if Net Working Capital increases?
Since you subtract the change in Net Working Capital in the calculation of Free Cash Flow, if Net Working Capital increases, your F ree Cash F low will decrease.
Industry specific mutiples?
Technology (Internet): EV / Unique Visitors, EV / Pageviews • Retail / Airlines: EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rental Expense) • Oil & Gas: EV / EBITDAX (Earnings Before Interest, Taxes, Depreciation, Amortization & Exploration Expense), EV / Production, EV / Proved Reserves
How do you select Comparable Companies or Precedent Transactions?
The 3 main criteria for selecting companies and transactions: 1. Industry classification 2. Financial criteria (Revenue, EBITDA, etc.) 3. Geography For Precedent Transactions, you also limit the set based on date and often focus on transactions within the past 1-2 years.
Why would a company distribute its earnings through dividends to common stockholders?
The distribution of a dividend signals to the public that a company is healthy and profitable and it can also attract more investors, potentially driving up the company's stock price.
How would you value an apple tree?
The same way you would value a company: by looking at what comparable apple trees are worth (relative valuation) and the present value of the apple tree's cash flows (intrinsic valuation). Yes, you could build a DCF for anything - even an apple tree.
How to calculate uFCF
There are several methods (see the DCF section), but the simplest ways: Unlevered FCF = EBIT * (1 - Tax Rate) + Non-Cash Charges - Change in Operating Assets and Liabilities - CapEx With Unlevered FCF, you're excluding interest income and expenses, as well as mandatory debt repayments.
What would you use with Free Cash Flow multiples - Equity Value or Enterprise Value?
Trick question. For Unlevered Free Cash Flow (Free Cash Flow to Firm), you would use Enterprise Value, but for Levered Free Cash Flow (Free Cash Flow to Equity) you would use Equity Value (see the diagram above).
What's minority interest
When company A owns 60% of Company X, 100% of Company X's earnings is recorded on A's books so you need to add the other 40% of Company X to account for other stakeholders.
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?
You use Enterprise Value because 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 and AFFO above).
11. How do you apply the valuation methodologies to value a company?
You would present everything in a "Football Field" graph To do this, you need to calculate the minimum, 25th percentile, median, 75th percentile, and maximum for each set (2-3 years of comps and the transactions, for each different multiple used) and then multiply by the relevant metrics for the company you're analyzing
when valuing private company, why discount trading comp but not transaction comp
in transactions, you acquire the whole company. shares become illiquid immediately
Which valuation technique yields the highest valuation? Least?
the highest valuation will normally come from the Precedent Transactions technique because a company will pay a premium for the projected synergies coming from the merger. A DC F will normally give you the next highest valuation simply because those building the DC F tend to be somewhat optimistic in the assumptions and projections going into their model. Market Comps and Market Value will normally give the lowest valuation.
How to calculate FCF?
𝐸𝐵𝐼𝑇(1 − 𝑇) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 & 𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 − Δ𝑁𝑊𝐶 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
What is operating leverage?
Operating leverage is the percentage of costs that are fixed versus variable. A company whose costs are mostly fixed has a high level of operating leverage.
if you are buying a company 1, assets are owned and depreciated 2. assets are leased depreciation = lease money and everything else is same which would you pay higher multiple for
choose 2. leased. Enterprise value would be the same but depreciation is not accounted for in EBITDA (artificially inflated). Multiple is lower as a result.
How would a $10 increase in depreciation in year 4 affect the DCF valuation of a company?
A $10 increase in depreciation decreases EBIT by $10, therefore reducing EBIT(1-T) by $10(1-T). Assuming a 40% tax rate, it drops EBIT(1-T) by $6, but you must add back the $10 depreciation in the calculation of F ree Cash F low. Therefore your F C F increases by $4 and your valuation will increase by the present value of that $4, the equation for PV is below.
When is a DCF useful? When is it not so useful?
A DCF is best when the company is large, mature, and has stable and predictable cash flows (think: Fortune 500 companies in "boring" industries). Your far-in-the-future assumptions will generally be more accurate there. A DCF is not as useful if the company has unstable or unpredictable cash flows (tech start-up) or when Debt and Operating Assets and Liabilities serve fundamentally different roles (ex: Banks and Insurance Firms - see the industry-specific guides for more).
Why is leverage good/important & how to calculate leverage
Leverage helps reduce the initial amount of equity needed, which helps to increase the internal rate of return. Leverage is some form debt in the numerator (total debt, net debt, total senior secured) divided by EBIT/EBITDA/EBITDAR/ect.
When should a company issue equity rather than debt to fund its operations?
- New projects the company plans on investing in may not produce immediate or consistent cash flows to make interest payments - The company may want to adjust its capital structure, or pay off debt - If their stock price is inflated, they would raise a relatively significant amount of capital for the percentage of ownership sold
What are some flaws with Precedent Transactions?
- 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 comparable, especially for acquisitions of small, private companies.
What is Beta?
- Represents relative volatility or risk of a given investment with respect to the market - β< 1 means less volatile than market (lower risk, lower reward) - β > 1 means more volatile than market (higher risk, higher reward) - A beta of 1.2 means that an investment will theoretically be 20% more volatile than the market. If the market goes up 10%, that investment should go up 12%.
Where do you find the risk free rate?
- The risk free rate is usually the current yield on the 10-year government treasury which can be found on the front page of The Wall Street Journal, on Yahoo! Finance, etc. - This is considered "risk-free" because the U.S. government is considered to be a risk-free borrower meaning the government should never default on its debt.
Examples of commonly used multiples & what they mean
-- EV / EBITDA - How valuable is a company in relation to its approximate cash flow. -- P/E - How valuable is a company in relation to its after-tax profits, inclusive of interest income and expense and other non-core business activities. -- EV / EBIT - How valuable is a company in relation to the pre-tax profit it earns from its core business operations -- EV/Revenue - How valuable is a company in relation to its overall sales
What is valuation?
-- Valuation is the procedure of calculating the worth of an asset, security, company, etc. -- This is one of the primary tasks that investment bankers do for their clients. Value their company, or value a company they are thinking about purchasing or divesting. -- Valuation is the procedure of calculating the worth of an asset, security, company, etc.
Comparable Companies / Multiple Analysis
-- an analyst will take the average multiple from comparable companies (based on size, industry, etc) and use that multiple with the operating metric of the company he or she is valuing -- The most commonly used multiple is Enterprise Value/EBITDA -- For example, if comparable Company A is trading at an EV/EBITDA multiple of 6.0x, and the company you are valuing has EBITDA of $100 million, their EV would be valued at $600 million based on this valuation technique.
Precedent Transactions?
-- an analyst would need to research historical transactions that are similar to the transaction in question. This would include looking at the size of the companies involved, their industry, the economic situation at the time of the transaction, etc. Once an analyst has found transactions that are comparable, they look at how those companies were valued. What were the EV/EBITDA and EV/Sales multiples paid? They would calculate a valuation multiple based on the sale prices in those transactions, and apply the multiple to the appropriate metric of the company being valued. Most of the time this valuation technique will result in the highest valuation due to the inclusion of the "control premium" a company is willing to pay for the assumed "synergies" they hope will occur after the purchase.
Describe a company's typical capital structure
1) A company's capital structure is made up of debt and equity, but there may be multiple levels of each 2) Debt can be broken down into senior, mezzanine and subordinated, with senior being paid off first in the event of bankruptcy, then mezzanine, then subordinated. Since senior is paid off first, it will have a lower interest rate. Debt may consist of bank loans (which are normally most senior in the capital structure) and/or bonds which can be issued to the general public. 3) Equity can also be broken down into preferred stock and common stock. Preferred stock is like a combination of debt and equity in that it has the opportunity for some appreciation in value, but more importantly pays out a consistent dividend that is not tied to the market price of the stock. Common stock is the final piece of the capital structure, and is the stock that is traded on the exchanges if the company is public.
Walk me through a DCF
1) we need to first project free cash flows for a period of time, usually five to ten years. Free cash flow is equal to EBIT (earnings before interest and taxes) times (1- the tax rate) plus Depreciation and Amortization minus Capital Expenditures minus the Change in Net Working Capital 2) we must predict the free cash flows for the years beyond the five or ten years we have projected. To do this we must establish a terminal value, as is detailed in the next question below. 3) must calculate the present value of those cash flows. To do this we must establish an appropriate discount rate. This discount rate is the Weighted Average Cost of Capital, or WACC. The calculation of WACC is discussed two questions below 4) The final cash flow (CFn) in the analysis will be the sum of the terminal value calculation and the final year's free cash flow
How to value a private company
1. 10-15% discount to public comps since not liquid 2. can't use premium analysis or future share price analysis 3. valuation shows enterprise value rather than implied per share price 4. estimate WACC based on comps
Walk me through an LBO?
An LBO (leveraged buyout) is when a firm (usually a Private Equity firm) uses a higher than normal amount of debt (known as leverage) to finance the purchase of a company. The PE investors will purchase the company with a percentage (anywhere from 10% to 40%) of its own equity capital, and the remainder will be financed with debt either through bank loans, bonds or a combination of the two. The PE firm then uses the cash flows from the acquired company to pay off the debt over time. Many times the PE Firm uses the assets of the company being acquired as collateral for the loan. When the PE firm is ready to sell the company, ideally the debt has been partially or fully paid off and they can collect most of the profits from the sale as the majority equity owners of the company. Since a smaller equity check was needed up front due to the higher level of debt used to purchase the company, this can result in higher returns to the original investors than if they had paid for the company with entirely their own equity (i.e. without any debt).
What kind of an investment would have a negative beta?
An investment with a negative beta is one which moves opposite the stock market as a whole. In other words, if the stock market moves up, the value of the negative beta investment would drop.
When should an investor buy preferred stock?
An investor should buy preferred who wants the upside of potential of equity, but wants to limit risk and provide themselves with the stability of current income in the form of a dividend. The investor would receive steady interest-like payments (dividends) that are more secure than the dividends from common stock. Preferred Stock owners also get a superior right to the company's assets should the company go bankrupt (although less rights than debtholders
How/why do you lever/unlever Beta?
By unlevering the beta, you are removing the financial effects from leverage (debt in the capital structure). This unlevered beta shows you how much risk a firm's equity has compared to the market. Comparing unlevered betas allows an investor to see how much risk they will be taking by investing in a company's equity (i.e. buying stock in the public market). When you have a Company A that doesn't have a beta, you can find comparable Company B, take their levered beta, unlever it, and then relever it using the Company A's capital structure to come up with their beta.
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?
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, insurance firms, and other companies where interest is critical and where capital structures tend to be similar. - EV / EBIT includes Depreciation & Amortization, whereas EV / EBITDA excludes it - you're more likely to use EV / EBIT in industries where D&A is large and where Capital Expenditures and fixed assets are important (e.g. manufacturing), and EV / EBITDA in industries where fixed assets are less important and where D&A is comparatively smaller (e.g. Internet companies).
What are some problems with EBITDA and EBITDA multiple? And if there are so many problems, why do we still use it?
Problems - Hides amount of debt principal and interest that a company is paying each year, which can be very large and may make the company cash flow-negative; as mentioned above, it also hides CapEx spending, which can also be huge. - ignores working capital requirements (e.g. Accounts Receivable, Inventory, Accounts Payable), which can be very large for some companies - companies like to "add back" many charges and expenses to EBITDA Pros - Convenient proxy for free cash flow - it's better for comparing the cash generated by a company's core business operations than other metrics - so you could say that EBITDA is more about comparability than cash flow approximation.
What is CAPM
The Capital Assets Pricing Model is used to calculate the required return on equity or the cost of equity. The return on equity is equal to the risk free rate (which is usually the yield on a 10-year U.S.government bond) plus the company's beta (which is a measure of how volatile the stock is in relation to the stock market) times the market risk premium.
What is the market risk premium?
The market risk premium is the required return that investors require for investing in stocks over investing in "risk-free" securities. It is calculated as the average return on the market minus the risk free rate (current yield on a 10-year treasury)
Why do you project out free cash flows for the DCF model
The reason you project F C F for the DCF is because F C F is the amount of actual cash that could hypothetically be paid out to debt holders and equity holders from the earnings of a company.
What are some ways to value a company?
There are a number of ways to value a company. The most simple would be the market valuation, which is just the equity value of the company based on the public markets - this is simply the market capitalization of the company plus the net debt on its books to get to total enterprise value. You can also use comparable company analysis, precedent transactions analysis, discounted cash flow analysis as well as a leverage buyout valuation
How to calculate terminal value?
There are two ways 1) Use the perpetuity growth formula. To use this method, you choose a modest growth rate, usually just a bit higher than the inflation rate or GDP growth rate, in order to assume that the company can grow at this rate infinitely. We then multiply the FC F from the final year by 1 plus the growth rate, and divide that number by the discount rate (WACC) minus the assumed growth rate 2) Terminal multiple method - you assign a valuation multiple (such as EV/EBITDA) to the final year's projection, and use that as your "terminal value" of the firm In either case, you must remember to still discount this "cash flow" back to year zero as you have with all other cash flows in the DCF model.
when not to use DCF
Unstable/unpredictable cashflows or when debt and working capital serve fundamentally different roles (FIG)
How to Calculate WACC?
WACC = (E/V x Re) + ((D/V x Rd) x (1 - T)) Where: E = market value of the firm's equity (market cap) D = market value of the firm's debt V = total value of capital (equity plus debt) E/V = percentage of capital that is equity D/V = percentage of capital that is debt Re = cost of equity (required rate of return) Rd = cost of debt (yield to maturity on existing debt) T = tax rate
What is WACC / How to Calculate WACC?
WACC stands for Weighted Average Cost of Capital. It is used as the discount rate in a discounted cash flow analysis to calculate the present value the company's cash flows and terminal value and reflects the overall cost of a company raising new capital, which is also a representation of the riskiness of an investment in the company. WACC represents the blended cost to both debt holders and equity holders of a firm based on the cost of debt and cost of equity for that specific firm.
What could a company do with excess cash on its balance sheet?
While at first it may seem that having a lot of cash on hand would be a good thing, especially in a recession, there is an opportunity cost to holding cash on the balance sheet. A company should have enough cash to protect itself from bankruptcy in a downturn, but above that level the cash should be used in one way or another. The main ways a company could use its cash would be to either reinvest into the firm (whether it be equipment, employees, marketing, etc) or the company could pay out the excess earnings/cash in the form of a dividend to its equity holders. A growing company will tend to reinvest rather than paying a dividend. Other ways the cash could be spent would include paying off debt, repurchasing equity, or buying out a competitor/supplier/distributor.
What is Net Working Capital?
𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 An increase in net working capital is a "use of cash" which could take the form of investing in current assets like inventory or increasing accounts receivable due to slower collections, for example. A decrease in net working capital is a "source of cash", which would include changes such as increasing accounts payable or a drop in inventory. This is why in calculating free cash flow you subtract an increase in net working capital. If net working capital went up a company must have "used" cash to cause this increase (for example, they purchased more inventory than they sold).
