Chapter 5 Valuation

Question 1

How do you value companies?

Answer 1

There are three primary methodologies: comparable analysis, precedent transaction analysis and discounted cash flow analysis (DCF)

Question 2

What is total enterprise value?

Answer 2

Total Enterprise Value is the value of operations of a firm attributed to all providers of capital

Question 3

Enterprise Value Formula

Answer 3

EV= Market Value of Equity + Debt + Preferred stock + Non Controlling Interest - Cash

Question 4

Difference between Total Enterprise Value and Equity Value

Answer 4

Enterprise value is the value of operations of a company attributed to all providers of capital. Equity value represents only the value to shareholders.

Question 5

What is Noncontrolling Interest

Answer 5

The balance sheet´s noncontrolling interest reflects the % of book value of a (majority but not wholly owned) subsidiary that a company does not own (usually >50%).

Question 6

Why do you add noncontrolling interest in EV

Answer 6

Firms with subsidiaries have to consolidate their balance sheets. This means that the denominator will use noncontrolling interest in valuation ratios. When we calculate valuation ratios then in the numerator we use EV and the denominator so this is done to have an accurate comparison.

Question 7

Why do we substract cash from EV

Answer 7

Cash is a nonoperating asset and cash is implicitly accounted within the equity value

Question 8

How to calculate MV of equity

Answer 8

Share price multiplied by the number of fully diluted shares outstanding

Question 9

Difference between basic and fully diluted shares

Answer 9

Basic shares is the number of common shares outstanding today. Fully diluted shares also take into account the potentially dilutive effect of any outstanding stock options, warrants, convertible preferred stock or convertible debt.

Question 10

Calculate fully diluted shares using treasury stock method

Answer 10

First we take the amount of the company´s issued stock options and weighted average excersise prices from the 10-k. If the calculation is for M&A or precedent transaction then we use all options outstanding (all are vested upon purchase). Otherwise we use only options excersisable which are only the ones which have vested. When we have this we subtract the excersise price of the options from current share price, divide the share price and multiply by the number of options outstanding. We do this calculation for each subset of options. Options with an excersise price greater than share price are out of the money and don´t have a diluitive effect. We then add the number of dilutive shares to the basic share count to get fully diluted shares.

DilutiveShares= OptionsOutstanding×(SharePrice− ExcersisePrice/ Share Price)
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Question 11

The Treasury Stock Method, explain the theory

Answer 11

The TSM method models how many shares would be created if in the money stock options were excersised. It assumes the company uses the cash it receives to buy back shares at the current market price.

Question 12

Examples of Valuation Multiples

Answer 12

EV/EBITDA; EV/Sales; P/E; always have a value metric on the numerator and an operating metric on the denominator

Question 13

Why don´t we use multiples such as EV/Earnings or price/EBITDA

Answer 13

Enterprise Value (EV) equals the value of operations of the company attributable to all providers of capital. This means that EV is independent of capital structure so we have to use an unlevered operating metric in the denominator such as EBITDA. Earnings is affected by debt and interest and thus is is affected by capital structure.

Question 14

Factors to consider when picking comps

Answer 14

We aim to find companies in the same industry, same type of business model, similar geography, similar size, growth and risk characteristics

Question 15

Walk me through a DCF!!!

Answer 15

The first step is to project free cash flow for a period, usually five years. Free Cash Flow is EBIT (1-tc) + D&A less CAPEX less change in net working capital. This free cashflow is unlevered.
Then we predict the terminal value which is the value of the assets for years beyond the projection period. We can use Gordon Growth method or Terminal Multiple Method. GGM we get an appropriate rate for eternal growth (long term avg. GDP growth). To calculate terminal value we multiply final year´s FCF_5(1+g) / r-g
Terminal Multiple Method is more popular. We take an operating metric for the last projected year and multiply is by an appropriate Valuation multiple. Usually we use EBITDA as the operating metric and an LTM EBITDA multiple (EV/EBITDA)
Then we discount eh FCFs and Terminal value using the discount rate WACC to discount it to present value. We want to use WACC with an optimal structure and DCF is a representation of Enterprise Value

Question 16

Why do you use unlevered free cash flow

Answer 16

We use it because we want the DCF value to be enterprise value. If we took into account levered FCF with taxes and interests then what is left is the money left for shareholders not debt holders.

Question 17

Free Cash Flow calculation

Answer 17

FCF= EBIT(1-tc) + D&A - CAPEX - change in NWC

Question 18

Whats is Terminal Value and how is it calculated?

Answer 18

Terminal value is the value of the company beyond the projection period. The first method is perpetuity growth (GGM). Here we choose an appropriate rate in which the company grows forever such as long term avg. GDP or inflation. Then we do FCF_5(1+g)/r-g where r is WACC.
The terminal multiple method we take an operating metric, usually EBITDA and a valuation metric, usually EV/EBITDA (LTM) and then multiply both to give a valuation. EBITDA multiple is usually taken from comparable company analysis.

Question 19

Why do we do present value of cash flows

Answer 19

This is due to money today being worth more than money tomorrow due to the time value of money

Question 20

What is WACC

Answer 20

WACC represents the company´s blended cost of funds or the investor´s blended required return for a company of this type of risk

Question 21

WACC formula

Answer 21

WACC= E/E+D+Pre + D/E+D+P(1-tc)rd + P/E+D+Prp where P is preferred stock

Question 22

Cost of Equity

Answer 22

To calculate cost of equity we use the CAPM formula. Which is the risk free rate plus beta time market risk premium. The risk free rake is generally the yield on a 10 or 20 yr US Treasury Bond. Beta should be levered and represents riskiness of the company´s equity relative to the overall equity markets. Equity risk premium is how much stocks are expected to outperform the risk free rate.

Question 23

What is Beta

Answer 23

Beta is a measure of the riskiness of a stock relative to the broader market. A stock with a beta higher than one is more risky than the market and vice versa. Beta is calculated as the covariance between a stock´s return and the market return divided by the variance of market return.

Question 24

Why do we lever and unlever betas?

Answer 24

To calculate CAPM we need to estimate an appropriate beta. We typically get the appropriate beta from comparable companies. The beta we obtain is levered. Stocks of companies with debt are riskier than those without debt due to risk of bankruptcy and distress costs. Debt reduces flexibility of management which makes owning equity riskier. We must first take out the impact of debt from the industry beta which is unlevering beta. We then use the mean of the unlevered betas and relever it for the appropriate capital structure this is relevering, then we use it in CAPM.

Question 25

Formulae for levering and unlevering beta?

Answer 25

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

Question 26

How do you calculate cost of debt

Answer 26

There are three methods. First method is to calculate the weighted average cost of debt for each comparable companies based on the different types of debt outstanding, the appropriate rates and yields on each of the types of debt, then use the mean/median. The second is to take average credit rating for the comparable companies and look up appropriate YTM on bonds of that credit rating. The third is the least accurate and we take interest expense for each comparable company and divide by the company´s avg. debt then take the median or mean. Then for all we multiply by one minus tax rate to calculate post tax cost of debt.

Question 27

How would you value a biotech startup with one potential blockbuster drug that is currently in trials?

Answer 27

Do a DCF assuming the drug passes trials but then you probability weight the DCF value based on chances of drug passing.

Question 28

How do you use the three main valuation methods to conclude value

Answer 28

Calculate a valuation range for each of the methods then triangulate the three ranges to conclude a valuation range for the company. Also use judgement, you can put more weight on the more accurate predictions.

Question 29

Which methodology gives higher and lower values?

Answer 29

Precedent transactions is likely to give a higher valuation than comps because of the premium paid for control.DCF also results in higher valuation than comps because DCF is a control based methodology as projections tend to be optimistic. DCF are more sensitive to assumptions and variables than precedent.

Question 30

Advantages and Disadvantages of the methodologies?

Answer 30

Advantage of comps is that it uses current market values to create a valuation so it is the most precise if there are good comps. It is less useful if there are no good comps or companies with no revenue/EBITDA/ net income because of ratios. Precedent transactions reflects value companies are willing to pay for other firms, accurate if the industry is facing heavy M&A flow. Disadvantage is that it is sensitive to market conditions and often the universe of comps spans multiple economic cycles. Deal dynamics also can affect the precedent analysis and this methodology shows a wider range of variables than comps. DCF advantages is that it can be done on any type of company, due to sensitivity analysis we can get a range of values. DCF however is very sensitive to cash flow forecast and its other variables so it is easy to make it unreliable.