Week 4

Question 1

What is the equity valuation?

Answer 1

estimate a value for a firm or its security

Question 2

Three primary equity valuation models:

Answer 2

Discount cash flow (DCF)
Cost
Comparable (or comparable approach)

Question 3

What is the comparables approach?

Answer 3

entity’s value should bear some resemblance to other equities in a similar class (relative valuation approach)

Question 4

Two primary comparables approach

Answer 4

First (most common) looks at market comparables for a firm and its peers
Second looks at market transactions where similar firms or divisions have been bought out or acquired by other rivals, private equity firms or other classes of large, deep-pocketed investors

Question 5

What is a comparable company analysis (CCA)?

Answer 5

Calculate a company’s “implied value” (what it should be worth) based on what other, similar companies are worth

Question 6

What are the steps for CCA?

Answer 6

1. Select an appropriate set of comparable PUBLIC companies
2. Determine the metrics and multiples you want to use
3. Calculate the metrics and multiples for the companies
4. Apply the median or 25th/75th percentile multiples from the set to your company to estimate its Implied Equity Value and Enterprise Value

Question 7

How many companies should be in a set?

Answer 7

50 is too many to be useful, 1-2 does not have enough data

Question 8

Formula for company value

Answer 8

Company value = cashflow / (discount rate - CF growth rate)

Where CF growth rates must be < discount rate

Question 9

If one company has a higher expected growth rate, it _______ trade at higher multiples

Answer 9

Should

Question 10

Calculate the company’s equity value and enterprise value based on…

Answer 10

current share price, shares outstanding, and balance sheet

Question 11

What is law of one price?

Answer 11

• firms which generate identical cashflows will have the same value
• identical assets will have the same price regardless of where they are traded (firms which generate identical cashflows and the same growth rate prospects, no matter which industry)

Question 12

What do analysts look for?

Answer 12

1. Comparison firms that have similar future prospects
2. No fundamental differences between firms
3. Same growth rates
4. Same cost of capital (discount rate)
5. Industry (or comparison set) is correctly valued

Question 13

Formula for P/E ratio

Answer 13

Share price / earnings

Question 14

What does price / earnings ratio mean?

Answer 14

• Meaningless for a company with little to no earnings

- Does not take capital structure (risk) into consideration

Question 15

What does price / book ratio mean?

Answer 15

• Measures how much an investor is willing to pay for each dollar of book value
• One would think that purchasing shares in a Company at less than book value (ie. Price/Book < 1) would be a good investment
• Advantages of using this metric are that book value is – - Commonly used for comparing financial firms as the assets and liabilities of a financial firm are well represented by book value

Question 16

Disadvantages to price / book ratio

Answer 16

• Book value does not do a good job of capturing the value of non-physical assets (patents, trademarks, intellectual property, etc.)
• Book value becomes less relevant as physical assets age
• Accounting policies and share repurchases impact the relationship between market value and book value
• NOTE: metric is never used when analyzing technology-based firms

Question 17

What does price / sales ratio mean?

Answer 17

• Measures what an investor is willing to pay for each dollar of sales a Company is able to generate
• Sales are always a positive number
• Very difficult for a Company to manipulate the reported sales figure (accounting perspective)
• Stable metric
• Commonly used to compare technology-based companies which have yet to mature to the point where earnings have become reliable and consistent

Question 18

What does price / cash flow ratio mean?

Answer 18

• Measures what an investor is willing to pay for each dollar of Cash Flow a Company is able to generate
• Consistent with the idea that the value of any asset is equal to the present value of future cash flows
• Issue: determining the definition of cash flow (many variations)
• Must stay consistent to calculate the cash flow generated by all firms in the compset

Question 19

Main issues associated with using price-based valuation metrics is that…

Answer 19

they fail to consider the Company’s capital structure (risk level associated)

Question 20

What is enterprise value (EV)?

Answer 20

measure of a company’s total value, often used as a more comprehensive alternative to equity market capitalization

Question 21

Formula for enterprise value

Answer 21

Market Value of Equity + Debt - Cash

Question 22

Formula for debt

Answer 22

Long term debt + Current portion of LT Debt + Pension Obligations + Preferred Shares

Question 23

What does EV / EBITDA ratio mean?

Answer 23

• Numerator in a valuation metric represents what an investor is paying while the denominator represents what the investor is getting in return
• EV/EBITDA metric can be interpreted as what is an investor paying for a dollar’s worth of cash flow (EBITDA is a rough estimate of cash flow)

Question 24

Advantages and disadvantages of EV / EBITDA

Answer 24

• advantages of being appropriate for comparing firms with different levels of leverage
• Disadvantages with using this metric is there are better estimates of cash flow than EBITDA (academic perspective)

Question 25

What does EV / revenue ratio mean?

Answer 25

• Metric is similar to Price/Sales with the exception that we are compensating for different capital structures
• Commonly used for companies that do not produce consistent cash flows or earnings