Valuation (Advanced) from BIWS 400 Flashcards

1
Q

How do you value banks and financial institutions differently from other companies?

A

For relative valuation, the methodologies (public comps and precedent transactions) are the same but the metrics and multiples are different:

  • You screen based on assets or deposits in addition to the normal criteria.
  • You look at metrics like ROE (Return on Equity, Net Income / Shareholders’ Equity), ROA (Return on Assets, Net Income / Total Assets), and Book Value and Tangible Book Value rather than Revenue, EBITDA, and so on.
  • You use multiples such as P / E, P / BV, and P / TBV rather than EV / EBITDA.

Rather than a traditional DCF, you use 2 different methodologies for intrinsic valuation:

  • In a Dividend Discount Model (DDM) you sum up the present value of a bank’s dividends in future years and then add it to the present value of the bank’s terminal value, usually basing that on a P / BV or P / TBV multiple.
  • In a Residual Income Model (also known as an Excess Returns Model), you take the bank’s current Book Value and simply add the present value of the excess returns to that Book Value to value it. The “excess return” each year is (ROE * Book Value) – (Cost of Equity * Book Value) – basically how much the returns exceed your expectations.

You need to use these methodologies and multiples because interest is a critical component of a bank’s revenue and because debt is a “raw material” rather than just a financing source; also, banks’ book values are usually very close to their market caps.

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2
Q

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

A
  1. Unlike normal valuations, in an IPO valuation we only care about public company comparables.
  2. After picking the public company comparables we decide on the most relevant multiple to use and then estimate our company’s Enterprise Value based on that.
  3. Once we have the Enterprise Value, we work backward to get to Equity Value and also subtract the IPO proceeds because this is “new” cash.
  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.

If you were using P / E or any other “Equity Value-based multiple” for the multiple in step #2 here, then you would get to Equity Value instead and then subtract the IPO proceeds from there.

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3
Q

I’m looking at financial data for a public company comparable, and it’s April (Q2) right now. Walk me through how you would “calendarize” this company’s financial statements to show the Trailing Twelve Months as opposed to just the last Fiscal Year.

A

The “formula” to calendarize financial statements is as follows:

TTM = Most Recent Fiscal Year + New Partial Period – Old Partial Period

So in the example above, we would take the company’s Q1 numbers, add the most recent fiscal year’s numbers, and then subtract the Q1 numbers from that most recent fiscal year.

For US companies you can find these quarterly numbers in the 10-Q; for international companies they’re in the interim reports.

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4
Q

Walk me through an M&A premiums analysis.

A

The purpose of this analysis is to look at similar transactions and see the premiums that buyers have paid to sellers’ share prices when acquiring them. For example, if a company is trading at $10.00/share and the buyer acquires it for $15.00/share, that’s a 50% premium.

  1. First, select the precedent transactions based on industry, date (past 2-3 years for example), and size (example: over $1 billion market cap).
  2. For each transaction, get the seller’s share price 1 day, 20 days, and 60 days before the transaction was announced (you can also look at even longer intervals, or 30 days, 45 days, etc.).
  3. Then, calculate the 1-day premium, 20-day premium, etc. by dividing the pershare purchase price by the appropriate share prices on each day.
  4. Get the medians for each set, and then apply them to your company’s current share price, share price 20 days ago, etc. to estimate how much of a premium a buyer might pay for it.

Note that you only use this analysis when valuing public companies because 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 it is broader.

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5
Q

Walk me through a future share price analysis.

A

The purpose of this analysis is to project what a company’s share price might be 1 or 2 years from now and then discount it back to its present value.

  1. Get the median historical (usually TTM) P / E of your 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. Then, discount this back to its present value by using a discount rate in-line with the company’s Cost of Equity figures.

You normally look at a range of P / E multiples as well as a range of discount rates for this type of analysis, and make a sensitivity table with these as inputs.

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6
Q

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

A
  • 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, the screening criteria is similar – financial, industry, geography, and date.
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7
Q

Walk me through a Sum-of-the-Parts analysis.

A

In a Sum-of-the-Parts analysis, you value each division of a company using separate comparables and transactions, get to separate multiples, and then add up each division’s value to get the total for the company. Example:

We have a manufacturing division with $100 million EBITDA, an entertainment division with $50 million EBITDA and a consumer goods division with $75 million EBITDA. We’ve selected comparable companies and transactions for each division, and the median multiples come out to 5x EBITDA for manufacturing, 8x EBITDA for entertainment, and 4x EBITDA for consumer goods.

Our calculation would be $100 * 5x + $50 * 8x + $75 * 4x = $1.2 billion for the company’s total value.

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8
Q

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

A

You value NOLs based on how much they’ll save the company in taxes in future years, and then take the present value of the sum of tax savings in future years. Two ways to assess the tax savings in future years:

  1. Assume that a company can use its NOLs to completely offset its taxable income until the NOLs run out.
  2. In an acquisition scenario, use Section 382 and multiply the adjusted long-term rate (http://pmstax.com/afr/exemptAFR.shtml) by the equity purchase price of the seller to determine the maximum allowed NOL usage in each year – and then use that to figure out the offset to taxable income.

You might look at NOLs in a valuation but you rarely add them in – if you did, they would be similar to cash and you would subtract NOLs to go from Equity Value to Enterprise Value, and vice versa.

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9
Q

I have a set of public company comparables and need to get the projections from equity research. How do I select which report to use?

A

This varies by bank and group, but two common methods:

  1. You pick the report with the most detailed information.
  2. You pick the report with numbers in the middle of the range.

Note that you do not pick reports based on which bank they’re coming from. So if you’re at Goldman Sachs, you would not pick all Goldman Sachs equity research – in fact that would be bad because then your valuation would not be objective.

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10
Q

I have a set of precedent transactions but I’m missing information like EBITDA for a lot of the companies – how can I find it if it’s not available via public sources?

A
  1. Search online and see if you can find press releases or articles in the financial press with these numbers.
  2. Failing that, look in equity research for the buyer around the time of the transaction and see if any of the analysts estimate the seller’s numbers.
  3. Also look on online sources like Capital IQ and Factset and see if any of them disclose numbers or give estimates.
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11
Q

How far back and forward do we usually go for public company comparable and precedent transaction multiples?

A

Usually you look at the TTM (Trailing Twelve Months) period for both sets, and then you look forward either 1 or 2 years. You’re more likely to look backward more than 1 year and go forward more than 2 years for public company comparables; for precedent transactions it’s odd to go forward more than 1 year because your information is more limited.

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12
Q

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?

A

There’s no “rule” that says this is wrong or not allowed, but it can be misleading to compare companies with dramatically different margins. Due to basic arithmetic, the 40% margin company will usually have a lower multiple – whether or not its actual value is lower.

In this situation, we might consider screening based on margins and remove the outliers – you would never try to “normalize” the EBITDA multiples based on margins.

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13
Q

Walk me through how we might value an oil & gas company and how it’s different from a “standard” company.

A

Public comps and precedent transactions are similar, but:

  • You might screen based on metrics like Proved Reserves or Daily Production.
  • You would look at the above metrics as well as R/P (Proved Reserves / Last Year’s Production), EBITDAX, and other industry-specific ones, and use matching multiples.

You could use a standard Unlevered DCF to value an oil & gas company as well, but it’s also common to see a NAV (Net Asset Value) Model where you take the company’s Proved Reserves, assume they produce revenue until depletion, assign a cost to the production in each year, and take the present value of those to value the company.

There are also a host of other complications: oil & gas companies are cyclical and have no control over the prices they receive, companies use either “full-cost accounting” or “successful efforts accounting” and treat the exploration expense differently, and so on.

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14
Q

Walk me through how we would value a REIT (Real Estate Investment Trust) and how it differs from a “normal” company.

A

Similar to energy, real estate is asset-intensive and a company’s value depends on how much cash flow specific properties generate.

  • You look at Price / FFO per Share (Funds From Operations) and Price / AFFO per Share (Adjusted Funds From Operations), which add back Depreciation and subtract gains on property sales.
  • A Net Asset Value (NAV) model is the most common intrinsic valuation methodology; you assign a cap rate to the company’s forward NOI and multiply to get the value of its real estate, adjust and add its other assets, subtract liabilities and divide by its share count to get NAV per Share, and then compare that to its current share price.
  • You value properties by dividing Net Operating Income (NOI) (Property’s Gross Income – Operating Expenses and Property Taxes) by the capitalization rate (based on market data).
  • Replacement Valuation is more common because you can actually estimate the cost of buying new land and building new properties.
  • A DCF is still a DCF, but it flows from specific properties and it might be useless depending on what kind of company you’re valuing.
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15
Q

Why might discounted cash flow valuation be difficult to do for the following types of firms?

a. A private firm, where the owner is planning to sell the firm.
b. A biotechnology firm with no current products or sales, but with several promising product patents in the pipeline.
c. A cyclical firm during a recession.
d. A troubled firm that has made significant losses and is not expected to get out of trouble for a few years.
e. A firm that is in the process of restructuring, where it is selling some of its assets and changing its financial mix.
f. A firm that owns a lot of valuable land that is currently unutilized.

A

A. It might be difficult to estimate how much of the success of the private firm is due to the owner’s special skills and contacts.

B. Since the firm has no history of earnings and cash flow growth and, in fact, no potential for either in the near future, estimating near term cash flows may be impossible.

C. The firm’s current earnings and cash flows may be depressed due to the recession. Other measures, such as debt-equity ratios and return on assets may also be affected.

D. Since discounted cash flow valuation requires positive cash flows some time in the near term, valuing troubled firms, which are likely to have negative cash flows in the foreseeable future, is likely to be difficult.

E. Restructuring alters the asset and liability mix of the firm, making it difficult to use historical data on earnings growth and cash flows on the firm.

F. Unutilized assets do not produce cash flows and hence do not show up in discounted cash flow valuation, unless they are considered separately.

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16
Q

What are some signs that you might be using the incorrect assumptions in a DCF?

A

The most common signs of trouble are:
1. Too Much Value from the PV of Terminal Value – It usually accounts for at least 50% of the company’s total Implied Value, but it shouldn’t account for, say, 95% of its value.

  1. Implied Terminal Growth Rates or Terminal Multiples That Don’t Make Sense – If you pick a Terminal Multiple that implies a Terminal FCF Growth Rate of 8%, but the country’s long-term GDP growth rate is 3%, something is wrong.
  2. You’re Double-Counting Items – If an income or expense line item is included in FCF, you should not be counting it in the Implied Enterprise Value  Implied Equity Value calculation at the end, and vice versa if it’s excluded from FCF.
  3. Mismatched Final Year FCF Growth and Terminal Growth Rate – If the company’s Free Cash Flow is growing at 15% in the final year, but you’ve assumed a 2% Terminal Growth Rate, something is wrong. FCF growth should decline over time and approach the Terminal Growth Rate by the end of the explicit forecast period.
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17
Q

If your DCF seems off, what are the easiest ways to fix it?

A

The simplest method is to extend the explicit forecast period so that the company’s Free Cash Flow contributes more value, and so that there’s more time for FCF growth to slow down and approach the Terminal Growth Rate.

So if you’re using a 5-year forecast period, extend it to 10 or 15 years and reduce the company’s FCF growth in those extra years as it approaches maturity.

Finally, you’ll often have to reduce the Terminal Value by picking a lower Terminal Growth Rate or lower Terminal Multiple. Terminal Value tends to be overstated in financial models because people don’t understand the theory behind it.

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18
Q

Does a DCF ever make sense for a company with negative cash flows?

A

Yes, it may. A DCF is based on a company’s expected future cash flows, so even if the company is cash flow-negative right now, the analysis could work if it starts generating positive cash flow in the future.
If the company has no plausible path to positive cash flow or you can’t reasonably forecast cash flow, then the analysis doesn’t make sense.

19
Q

WHY do you calculate Unlevered Free Cash Flow by excluding and including various items on the financial statements?

A

Unlevered FCF must capture the company’s core, recurring items that are available to ALL investor groups. That’s because Unlevered FCF corresponds to Enterprise Value, which also represents the value of the company’s core business that’s available to all investor groups. So if an item is NOT recurring, NOT related to the company’s core business, or NOT available to all investor groups, you leave it out. This rule explains why you exclude all of the following items:

1) Net Interest Expense – Only available to Debt investors.
2) Other Income / (Expense) – Corresponds to non-core-business Assets.
3) Most non-cash adjustments besides D&A – They’re non-recurring.
4)The Cash Flow from Financing section – They’re available only to certain investors. 5) Most of Cash Flow from Investing – Only CapEx is a recurring, core-business item

20
Q

What’s the proper tax rate to use when calculating FCF – the effective tax rate, the statutory tax rate, or the cash tax rate?

A

The company’s Free Cash Flows should reflect the cash taxes it pays. So it doesn’t matter which rate you use as long as the cash taxes are correct.

For example, you could use the company’s effective tax rate (Income Statement Taxes / Pre-Tax Income), and then factor in Deferred Taxes within the non-cash adjustments. So if a company pays more or less in taxes than what it has recorded on its Income Statement, you could adjust afterward. Or you could calculate the company’s “cash tax rate” and skip the Deferred Tax adjustments. You could even use the statutory tax rate and make adjustments for state/local taxes and other items to arrive at the company’s real cash taxes.

It’s most common to use the effective tax rate and then adjust for Deferred Taxes based on historical trends.

21
Q

Should you reflect inflation in the FCF projections?

A

In most cases, no. Clients and investors tend to think in nominal terms, and assumptions for prices and salaries tend to be based on nominal figures. If you reflect inflation, then you also need to forecast inflation far into the future and adjust all figures in your analysis. This extra effort is probably not worth it because of the uncertainty and extra work.

22
Q

What’s the relationship between including an income or expense line item in FCF and the Implied Equity Value calculation at the end of the DCF?

A

If you include an income or expense in Free Cash Flow, then you should exclude the corresponding Asset or Liability when moving from Implied Enterprise Value to Implied Equity Value at the end (and vice versa for items you include).

For example, if you capitalize the company’s operating leases and count them as a Debt-like item at the end, then you should exclude the rental expense from FCF, making it higher.

This rule also explains why, in an Unlevered DCF analysis, you have to factor in Cash and Debt when moving to the Implied Equity Value: You’ve excluded the corresponding items on the Income Statement (Interest Income and Interest Expense).

23
Q

What does Beta mean intuitively?

A

Levered Beta tells you how volatile a company’s stock price is relative to the stock market as a whole, factoring in both the intrinsic business risk and the risk from leverage (i.e., Debt).

If Beta is 1.0, when the market goes up 10%, this company’s stock price also goes up by 10%. If Beta is 2.0, when the market goes up 10%, this company’s stock price goes up by 20%.

Unlevered Beta excludes the risk from leverage and reflects only the intrinsic business risk, so it’s always less than or equal to Levered Beta.

24
Q

Why do you have to un-lever and re-lever Beta when calculating Cost of Equity?

A

You don’t “have to” un-lever and re-lever Beta: You could just use the company’s historical Beta, i.e. its own Levered Beta, and skip this step.

But in a valuation, you’re estimating the company’s Implied Value – what it should be worth. If you use the historical Beta, that corresponds more closely to the company’s Current Value – what the market says it’s worth today.

By un-levering Beta for each comparable company, you isolate each company’s inherent business risk

Each company might have a different capital structure, so it’s important to isolate that risk and remove the risk from leverage. You then take the median Unlevered Beta from these companies and re-lever it based on the targeted capital structure of the company you’re valuing.

You do this because, in reality, there will always be business risk and risk from leverage, and so you need to reflect both for the company you’re valuing.

You can think of the result – Re-Levered Beta – as: “What the volatility of this company’s stock price, relative to the market as a whole, should be, based on the median business risk of its peer companies and this company’s targeted capital structure.”

25
Q

What are the formulas for un-levering and re-levering Beta, and what do they mean?

A

Assuming the company has only Equity and Debt:

Unlevered Beta = Levered Beta / (1 + Debt/Equity Ratio * (1 – Tax Rate))

Levered Beta = Unlevered Beta * (1 + Debt/Equity Ratio * (1 – Tax Rate))

If the company has Preferred Stock, you add another term for the Preferred/Equity Ratio.

You use a “1 +” in front of Debt/Equity Ratio * (1 – Tax Rate) to ensure that Unlevered Beta is always less than or equal to Levered Beta.

And you multiply the Debt/Equity Ratio by (1 – Tax Rate) because the tax-deductibility of interest reduces the risk of Debt.

The formulas reduce Levered Beta to represent the removal of risk from leverage, but they increase Unlevered Beta to represent the addition of risk from leverage.

26
Q

In those formulas (levered/unlevered beta formulas), you’re not factoring in the interest rate on Debt. Isn’t that wrong? More expensive Debt should be riskier.

A

Yes, this is one drawback of this approach. However:

  1. The Debt / Equity ratio is a proxy for interest rates on Debt because companies with high Debt / Equity ratios tend to have higher interest rates as well.
  2. The risk isn’t directly proportional to interest rates. Higher interest on Debt will result in lower coverage ratios (EBITDA / Interest) and, therefore, more risk, but it’s not as simple as saying, “Interest is now 4% rather than 1% – risk is 4x higher.”

4x higher interest might barely change a large company’s financial profile, but it might make a much bigger difference for a smaller company.

27
Q

Do you still un-lever and re-lever Beta even when you’re using Unlevered FCF?

A

Yes. Un-levering and re-levering Beta has nothing to do with Unlevered vs. Levered FCF. A company’s capital structure affects both the Cost of Equity and WACC, so you un-lever and re-lever Beta regardless of the type of cash flow in your analysis.

28
Q

How would you estimate the Cost of Equity for a U.S.-based technology company?

A

This question tests your ability to make a guesstimate based on common sense and your knowledge of current market rates. You might say, “The Risk-Free Rate is around 1.5% for 10-year U.S. Treasuries. A tech company like Salesforce is more volatile than the market as a whole, with a Beta of around 1.5. So if you assume an Equity Risk Premium of 8%, Cost of Equity might be around 13.5%.” The numbers will change based on market conditions, but that’s the idea.

29
Q

How do you determine the Cost of Debt and Cost of Preferred Stock in the WACC calculation, and what do they mean?

A

These Costs represent the marginal rates a company would pay if it issued additional Debt or Preferred Stock. There is no way to observe these rates, but you can estimate them.

One simple method is to calculate the weighted average coupon rate on the company’s existing Debt or Preferred Stock or to calculate the median coupon rate on the outstanding issuances of comparable companies.

You could also use the Yield to Maturity (YTM) instead, which reflects the market prices of the bonds (a bond with a coupon rate of 5% that’s trading at a discount to par value will have a YTM higher than 5%).

You could also take the Risk-Free Rate in the country and add a default spread based on the company’s expected credit rating if it issues more Debt or Preferred Stock (e.g., if you think its credit rating will go from BB+ to BB after issuing Debt, you’d calculate the average spread for BB+-rated companies and add it to the Risk-Free Rate).

30
Q

How do convertible bonds factor into the WACC calculation?

A

If the company’s current share price exceeds the conversion price of the bonds, you count the bonds as Equity and factor them in by using a higher diluted share count, resulting in a higher Equity Value for the company and a greater Equity weighting in the WACC formula.

If not – i.e., the bonds are not currently convertible – you count them as Debt and use the coupon rate (or YTM, or another method above) to calculate their Cost.

Convertible bonds almost always reduce WACC when they count as Debt since the Cost of Debt is lower than the Cost of Equity, and the coupon rates on convertible bonds are even lower than the rates on traditional bonds.

NOTE: This answer assumes that you’re calculating WACC based on the company’s current capital structure. If you’re using the optimal or targeted structure, the company’s convertible bonds won’t factor in.

31
Q

If a company previously used 20% Debt and 80% Equity, but it just paid off all its Debt, how does that affect WACC?

A

It depends on how you’re calculating WACC. If you’re using the company’s current capital structure, WACC will most likely increase because 20% Debt is a fairly low level. At that level, less Debt will most likely increase WACC. But if you’re using the targeted, optimal, or median capital structure from the comparable companies, this change won’t affect WACC because you’re not using the company’s current capital structure at all.

32
Q

Should you ever use different Discount Rates for different years in a DCF?

A

Yes, sometimes it makes sense to use different Discount Rates. For example, if a company is growing quickly right now, but it’s expected to mature and grow more slowly in the future, you might use decreasing Discount Rates. So if the company’s current WACC is between 11% and 13%, and WACC for mature companies in the industry is between 8% and 9%, you might start out at 12% and then reduce it by 0.5% in each year of the explicit forecast period until it reaches 8.5% at the end. It makes less sense to do this if the company is already stable and mature and it’s not expected to change much over time.

33
Q

What’s the intuition behind the Gordon Growth formula for Terminal Value?

A

The intuition is that a company is worth less if the Discount Rate is higher and worth more if the Terminal FCF Growth Rate is higher.

For example, let’s say the company’s FCF is not growing, and its Discount Rate is 10%. It has $100 in FCF in the first year of the Terminal Period. You would be willing to pay $100 / 10%, or $1,000, so the Terminal Value is $1,000. If the Discount Rate falls to 5%, now you’d pay $100 / 5%, or $2,000. If it increases to 20%, you’d pay $100 / 20%, or $500.

That’s because the company is worth more when you have worse investment options elsewhere, and worth less when you have better investment options elsewhere.

Now let’s say the company’s FCF is growing. If it grows by 3% per year, you’d be willing to pay $100 / (10% – 3%), or ~$1,429 for it. But if its FCF growth rate increases to 5% per year, you’d be willing to pay $100 / (10% – 5%), or $2,000, for it.

Higher growth lets you achieve the same targeted return even when you pay more.

34
Q

If you use the Multiples Method to calculate Terminal Value, do you use the multiples from Public Comps or Precedent Transactions?

A

The answer is: “Neither one – you just use them as starting points in the analysis, and then you adjust once you see the Terminal FCF Growth Rates that the selected multiples imply.”

It’s better to start with the multiples from the Public Comps, ideally the ones from 1-2 years into the future, because you don’t want to reflect the control premium inherent in Precedent Transactions. The company doesn’t necessarily “get sold” at the end of the forecast period; the Terminal Multiple is just an abbreviated way of expressing its valuation. Then, if the multiples imply a reasonable Terminal FCF Growth Rate, you might stick with your initial guess; if not, you adjust it up or down as necessary.

35
Q

What’s one problem with using EV / EBITDA multiples to calculate Terminal Value?

A

The biggest issue is that EV / EBITDA ignores CapEx. So two companies with similar EV / EBITDA multiples might have very different Free Cash Flow and FCF growth figures. As a result, their Implied Values might differ significantly even if one multiple is similar for both of them. You may get better results by using EV / EBIT, EV / NOPAT, or EV / Unlevered FCF, but those present other issues, such as less comparability across peer companies.

This problem is one reason why the Gordon Growth Method is still the “real” way to calculate Terminal Value.

36
Q

Would it ever make sense to use a negative Terminal FCF Growth Rate?

A

Yes. For example, if you’re valuing a biotech or pharmaceutical company and the patent on its key drug expires within the explicit forecast period, you might assume that the company’s cash flows eventually decline to 0. A negative Terminal FCF Growth Rate represents your expectation that the company will stop generating cash flow eventually. A negative Terminal FCF Growth Rate doesn’t make the company “worthless”; it just means that the Terminal Value will be much lower.

37
Q

How can you determine which assumptions to analyze in sensitivity tables for a DCF?

A

The same variables are important in any DCF: The Discount Rate, the Terminal FCF Growth Rate or Terminal Multiple, and the revenue growth and margin assumptions. It doesn’t make sense to sensitize much else – assumptions for CapEx and Working Capital, for example, make a very small difference. There may also be industry-specific assumptions that are worth sensitizing (e.g., the patent expiration date for a drug in biotech/pharmaceuticals).

38
Q

Two companies produce identical total Free Cash Flows over a 10-year period, but Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining 9 years. Company B generates the same amount of Free Cash Flow in each year. Which company will have the higher Implied Value?

A

This is a bit of a trick question because it depends on what you count toward the Implied Value. If it’s just this series of cash flows, Company A will have the higher Implied Value because of the time value of money: The cash flows arrive earlier on, so they’re worth more. However, Company B will almost certainly have a much higher Terminal Value because it has higher FCF in Year 10. So if the Terminal Value comprises a big portion of the Implied Value, and you count it in the analysis, it’s a good bet that Company B will have the higher Implied Value.

39
Q

How do higher vs. lower tax rates affect the Cost of Equity, Cost of Debt, WACC, and the Implied Value from a DCF?

A

The tax rate affects the Cost of Equity, Cost of Debt, and WACC only if the company has Debt. If the company does not have Debt, or its targeted/optimal capital structure does not include Debt, the tax rates don’t matter because there’s no tax benefit to interest paid on Debt. Assuming there’s some Debt, a higher tax rate will reduce Cost of Equity, Cost of Debt, and WACC. It’s easy to see why it reduces the Cost of Debt: Since you multiply by (1 – Tax Rate), a higher rate always reduces the after-tax cost.

But it also reduces the Cost of Equity for the same reason: With a greater tax benefit, Debt is less risky even to Equity investors. And if both of these are lower, WACC will also be lower. However, the Implied Value from a DCF will be lower because the higher tax rate reduces FCF and, therefore, the company’s Terminal Value. Those changes tend to outweigh a lower WACC. The opposite happens with lower taxes: Higher Costs of Equity and Debt, higher WACC, and a higher Implied Value from the DCF.

40
Q

Why is it important to select Public Comps and Precedent Transactions that are similar?

A

Because the comparable companies and transactions should have similar Discount Rates. Remember that a company’s valuation multiples depend on its Free Cash Flow, Discount Rate, and Expected FCF Growth Rate. If the companies in your set all have similar Discount Rates, it’s easier to conclude that one company has a higher multiple because its expected growth rate is higher. If they don’t have similar Discount Rates, it’s harder to draw meaningful conclusions.

41
Q

Are there any screens you should AVOID when selecting Comparable Companies and Precedent Transactions?

A

You should avoid screening by both financial metrics and Equity Value or Enterprise Value. For example, you should NOT use this screen: “Companies with revenue under $1 billion and Enterprise Values above $2 billion.” If you do that, you’re artificially constraining the multiples because EV / Revenue must be above 2x for every company in the set.

42
Q

How do you interpret the Public Comps? What does it mean if the median multiples are above or below the ones of the company you’re valuing?

A

The interpretation depends on how the growth rates and margins of your company compare to those of the comparable companies.

Public Comps are most meaningful when the growth rates and margins are similar, but the multiples are different. This could mean that the company you’re valuing is mispriced and that there’s an opportunity to invest and make money. For example, all the companies are growing their revenues at 10-15% and their EBITDAs at 15-20%, and they all have EBITDA margins of 10-15%. Your company also has multiples in these ranges. However, your company trades at EV / EBITDA multiples of 6x to 8x, while the comparable companies all trade at multiples of 10x to 12x.

That could indicate that your company is undervalued since its multiples are lower, but its growth rates, margins, industry, and size are all comparable. If the growth rates and margins are very different, it’s harder to draw conclusions since companies growing at different rates are expected to trade at different multiples.

43
Q

Why do Precedent Transactions often result in more “random” data than Public Comps?

A

The problem is that the circumstances surrounding each deal might be very different. For example, one company might have sold itself because it was distressed and about to enter bankruptcy. But another company might have sold itself because the acquirer desperately needed it and was willing to pay a high price. Some deals are competitive and include multiple acquirers bidding against each other, whereas others are more targeted and do not involve competitive bidding. All these factors mean that the multiples tend to vary widely, more so than the multiples for Public Comps.