VALUATION Flashcards
Valuation: Core Purpose?
Calculate Co’s IMPLIED Value and compare it w/ Co’s CURRENT value
- current value = markets could be wrong. value co’s to see if market is wrong.
- make recommendations to buy or not to buy a co (undervalued vs. overvalued)
- sell-side: what you can expect to get if you sell
Why is valuation more complicated than the simple formula of Company Value = Cash Flow / (Discount Rate - CF Growth Rate)?
In reality, the Discount Rate & CF Growth rate change over time.
What are 2 ways to more accurately value a company? (As compared to simple Company Value formula)
1) DCF Analysis: Valuing a co based on its CFs (often called intrinsic valuation)
2) Relative Valuation: Use valuation multiples
Discounted Cash Flow Analysis - what is it?
Valuing a co based on its CFs; this method is often called intrinsic valuation.
1) PROJECT CO’S CASH FLOWS in detail in explicit forecast period (usually next 5-15 years) (future). –> Discount these CFs to their Present Value ==> Add them up.
2) Then, assume the Co’s CF Growth Rate & Discount Rate stay the same in the TERMINAL PERIOD –> Find Terminal Value: value the CO in THAT TERMINAL PERIOD using the Company Value Formula = Cash Flow / (Discount Rate - CF Growth Rate) ==> Discount Co’s Terminal Value to its PV
3) Add PV of Terminal Value to Discounted CFs from first 5-15 years ==> = Implied Value of Co
What is the most THEORETICALLY correct way to value a co?
DCF - b/c valuing co based on its CFs, rather than external factors like other companies ==> often called “intrinsic valuation”
Relative Valuation - what is it?
Use VALUATION MULTIPLES for the company’s near-term financial results (ex: next 1-2 years) & don’t rely on long-term CF projections.
–> Valuation Multiples = shorthand for CF-based valuation
To use: 1) collect set of “comparable” companies and M&A transactions –> 2) calculate their valuation multiples –> 3) apply multiples to the co you are valuing
What type of CF to use in DCF?
Usually should use UNLEVERED FCF
- if you use unlevered -> DCF produces EV
- if you use levered -> DCF produce EqV, rather than EV
Unlevered Free Cash Flow (UFCF) - What is it/what does it represent? Advantages over other types of FCF?
UFCF = represents discretionary CF avail from core business to ALL investors.
2 main advantages over other types of FCF:
1) CONSISTENCY: UFCF does not depend on co’s capital structure => will get same results even if co issues Debt, Equity, repays Debt, etc.
2) EASE OF PROJECTING: Ignore Net Income Expense in the analysis ==> so, don’t need to project items like Debt, Cash, interest rates on Debt & Cash –> less research, faster conclusion
Unlevered FCF - What items should it consist of? What items to ignore & why?
UFCF = represents discretionary CF avail from core business to ALL investors.
Consists of:
1. (ADD) Revenue
2. (DEDUCT) COGS & Operating Expenses (deduct full Lease Expense as well!)
3. (DEDUCT) Taxes
4. (ADD) Depreciation & amoritization (and sometimes other non-cash add-backs)
5. (ADD OR DEDUCT) Change in Working Capital
6. (DEDUCT) Capital Expenditures
IGNORE: 1) Non-recurring items or 2) items that relate only to specific investor groups, rather than ALL investors.
(–> So, ignore: Net Interest Expense, Other Income / (Expense), MOST of the non-cash adjustments, CF from Financing section, most of CF from Investing section)
What “Non-Cash Adjustments” on CFS are included vs. excluded from Unlevered FCF?
- D&A is included. Sometimes Deferred Income Taxes are included, but not much else.
- MOST of non-cash adjustments are excluded b/c:
1) Most of them are non-recurring (ex: Gains & Losses, Impairments, Write-Downs). ==> So, when you PROJECT FCF: ignore non-recurring items in the future; or
2) Stock-based compensation (common, recurring item in non-cash adj section) = NOT a real non-cash expense & relates only to a specific investor group (common SHs)
Stock-based compensation (SBC) - is it a true non-cash expense?
No b/c it creates additional shares –> dilutes existing investors. ==> So, still costs you money)
==> So, can’t add SBC back to Unlevered FCF as non-cash expense. (Otherwise, not reflecting existing SHs’ reduced ownership in the Co)
Interest Expense and Other Expense / (Income) - why is it ignored in UFCF formula?
They’re only available to certain investor groups
Discount Rate - definition; implications of higher/lower Discount Rate
Discount Rate = Opportunity cost for investor: what they could earn by investing in other, similar companies
Higher Discount Rate = implies higher risk/potential returns; makes co LESS valuable - b/c means investor has better options elsewhere
Lower Discount Rate = implies lower risk/potential returns; makes co MORE valuable - b/c means investor has worse options elsewhere
Why do companies have multiple Discount Rates?
What are most impt Discount Rates for valuation/DCF purposes?
- Since co’s have multiple sources of capital (can invest in a co in diff ways: buy its shares, bonds, Preferred Stock, other securities) –> multiple Discount Rates ==> each part of capital structure has diff rate
- Most important Rates:
1) Cost of Equity: “opportunity cost” for common stock - what investors can earn from a) stock price increases & b) dividends
2) Cost of Debt: for co’s outstanding debt - represents “yield” investors can earn from a) interest payments and b) diff bt market value of debt & amount co will repay upon maturity
3) Preferred Stock: for Preferred Stock - similar to Cost of Debt (but Preferred Stock tends to have higher coupon rates & Preferred Dividends also are not tax-deductible)
Weighted Average Cost of Capital (WACC) - definition/intuition; formula; why does it always pair w/ unlevered FCF?
WACC = Cost of Equity * % of Equity + Cost of Debt * % of Debt * (1 - Tax Rate) + Cost of Preferred Stock * % of Preferred Stock
WACC = represents OVERALL Discount Rate for entire company
-If you invest proportionally in co’s entire capital structure –> WACC = expected, long-term annualized return
- to a co: WACC = cost of funding its operations by using ALL its sources of capital & keeping its cap structure %s the same over time
–> always pairs w/ UFCF b/c both represent ALL investors in the co
- investors: might invest in a co if its expected IRR exceeds WACC, and a co might decide to fund a new project, acq, or expansion if its expected IRR exceeds WACC
Cost of Debt & Cost of Preferred Stock: What do these rates represent? How to approximate?
Represents rates would pay if it issued ADDITIONAL Debt or Preferred Stock.
*can estimate:
- calculate weighted avg coupon rate on existing debt/pref stock
- median coupon rate on oustanding issuances of comparable public companies
==> Can’t predict, but can approximate: look at co’s current Debt & Preferred Stock
1) Coupon rate(s) –> approximate for Pre-Tax Cost of Debt
2) YTM
3) Risk-free Rate + “default spread” based on co’s expected credit rating after it issues additional debt
**
- look at comparable co’s / debt issues & int rates & yields issued by similar co’s to get estimates
Cost of Debt & Cost of Preferred Stock: Market Value vs. Face Value
Cost of Equity - definition; how to estimate - GENERAL
Represents how much a co’s stock “should” return each year, on avg, over long-term, factoring in both 1) stock-price appreciation and 2) dividends
- co “pays” for equity in 2 ways:
1) gives up stock appreciation rights to other investors (losing some of upside - non-cash expense)
2) issuing dividends (cash expense)
To estimate: usually use Capital Asset Pricing Model (CAPM) –
Cost of Equity = Risk Free Rate + Equity Risk Premium * Levered Beta
–> estimates co’s expected return b/c difficult in practice to est impact of both of these
Risk-Free Rate - definition; how to calculate
- Represents what you can earn (interest rate) on “riskless security” (“safe” govt bonds)
- usually, look at yields of 10 year government bonds (or 20 year bonds) in country of same currency as co’s CFs
- IF govt bonds in the co are NOT risk-free (ex: Greece): take Rf Rate from country that is (Ex: US, UK) & add a default spread based on co’s credit rating
–> intuition: add the default spread to show risk that this govt has a higher change of defaulting
Levered Beta - definition; how to calculate
Represents VOLATILITY of this stock relative to the market as a whole; reflects risk of both 1) co’s intrinsic business risk and 2) risk introduced by leverage (Debt)
Ex: If Beta = 1 –> when market goes up 10%, co’s stock goes up 10%.
Ex: If Beta = 0.5 –> when market goes up 10%, co’s stock goes up 5%
To calculate:
1) Easy Method = HISTORICAL Beta: based on co’s price history (stock performance vs. relevant index); or
2) Harder Method = Analyze comparable companies
- WHY?: 1) get proper range of values for COE => leads to range for WACC too and 2) point of valuation is to determine Co’s IMPLIED Value (contra: co’s past performance = more in line w/ Current Value)
*When you look up a co, it is already LEVERED: co’s previous stock price movements already priced in (reflects) the co’s debt they’ve taken on
Equity Risk Premium - how to calculate for multinational co in many geographies?
Equity Risk Premium - definition; how to calculate
- Represents percentage the stock market will return each year, on avg, above yield on “safe” govt bonds
–> EXTRA yield you can early by investing in an index that tracks stock market
–
To calculate: ALWAYS linked to company’s country & domestic stock market.
BUT 3 points of disagreement on how to calculate –
1) Historical vs. Projected numbers? – Projected ones make more sense, but how to “project” stock market?
2) Arithmetic vs. geometric mean?
3) Period?
==> Pick reasonable range of values (look at a few data sources), rather than argue for single #
–
- can take historical data from US stock market + add a premium based on default spread in a specific co
- some groups also use a standard # for each market (ex: 5-6% in developed countries)
Beta - intuition
- beta measures a co’s “risk” (compared to rest of the market
- Beta represent 2 types of risk:
1) inherent BUSINESS risk
2) risk from DEBT (leverage)
(ex: defaulting on debt; not being able to pay interest)
Beta - intuition behind using using comparable companies beta vs. historical beta?
- assumption that co’s “true” riskiness = more in-line w/ how risky similar co’s in the market are, than to its own historical track record
–> figuring out what a co’s beta SHOULD be, rather than what it currently is - in a valuation, trying to est a co’s implied value - what it should be worth.
- using historical beta corresponds more closely w/ co’s CURRENT value
Beta - Comparable Companies Analysis: How to calculate?
*intuition behind calculation: Since Beta reflects both 1) inherent business risk & 2) risk from leverage –> can’t just use median Beta from comparable companies b/c each comparable co has a diff capital structure –> so, risk from leverage will also be diff.
=> So, have to remove risk from leverage to ISOLATE INHERENT BUSINESS RISK of comparable companies.
To calculate:
1) Have to find UNLEVERED Beta for all comparable companies (reduce Beta by removing risk from leverage)
2) Calculate median Unlevered Beta
2) Then, have to RE-LEVER Beta –> to reflect risk from leverage of the co you’re valuing.
==> BUT: What Capital Structure to use?
How to UNLEVER Beta? - formula
Unlevered Beta = Levered Beta / (1 + Debt/Equity * (1-Tax Rate) + Preferred/Equity)
*trying to remove additional risk from debt w/ this calculation
- denom = “Let’s assume that this risk from Debt is directly proportional to the company’s Debt / Equity ratio. But remember that interest paid on Debt is also tax-deductible, and as a result that helps reduce the risk from Debt slightly, since we save on taxes.”
How to RE-LEVER Beta?
Levered Beta = Unlevered Beta * (1 + Debt/Equity * (1-Tax Rate) + Preferred/Equity)
Cost of Equity Formula: Capital Structure - Current vs. Optimal or Targeted
*BACKGROUND LOGIC: Don’t necessarily want to use co’s CURRENT capital structure (b/c trying to figure out implied VALUE) => USE “Optimal Capital Structure” or “targeted Capital Structure”
“Targeted Capital Structure” = what co plans to use
“Optimal Capital Structure” = mix of Debt, Equity, and Preferred Stock that minimizes WACC
IRL:
1) No co discloses their planned capital structures and hard to know cap structure will definitely change in certain, predictable way
2) “Optimal capital structure” = impossible to observe or calculate (can’t tell in advance what this co’s cap structure SHOULD be, not what it is right now)
–> So, to estimate “optimal” or “targeted” structure:
1) Find median capital structure percentages of comparable companies and
2) Apply them to your co
Cost of Equity: Diff methods (to establish a RANGE of Values)
Differs based on: 1) Historical Beta vs. Comp Companies Beta used and 2) Capital Structure used
1) COE based on Levered Beta from comparable companies & co’s current capital structure.
2) COE based on Levered Beta from comp companies & “optimal” capital structure
3) (EASY METHOD) COE based on co’s historical levered beta & current capital structure
What makes WACC tricky to calculate?
1) CAPITAL STRUCTURE: Can use either a) Co’s current capital structure or b) optimal/targeted cap structure for %s of Equity, Debt, Preferred Stock
2) COST OF EQUITY CALCULATION: Diff methods to calculate
3) EQUITY RISK PREMIUM: disagreements on how to calculate
4) COST OF DEBT & COST OF PREFERRED STOCK CALCULATION: Diff methods to calculate
==> Should focus on finding plausible range of values for WACC, rather than single number
Discounting Cash Flows: Should you use same discount rate (WACC) every year?
Discount each year’s UFCF to PV using formula: PV = Cash Flow / ((1 + Discount Rate)^Year #)
–> Co’s risk profile could change over time ==> so may not want to use same discount rate every year.
- IF Co grows & matures significantly in explicit forecast period => reasonable to start w/ higher Discount Rate –> gradually move to lower one
- IF Co is 1) mature & not expected to change significantly in the future and 2) other mature co’s in industry have WACCs in similar range => reasonable to use same WACC every year
Terminal Value - definition; ways to calculate
Co’s value in far-future period (Terminal Period)
2 methods to calculate:
1) Perpetuity Growth Method or Gordon Growth Method
2) Multiples Method
*the PV of the co’s FCFs from the final year into infinity, as of the final year.
Perpetuity Growth/Gordon Growth Method - formula & intuition behind formula
One way to calculate Terminal Value:
Terminal Value = Unlevered FCF in Year 1 of Terminal Period / (WACC - Terminal Unlevered FCF Growth Rate)
*LOGIC:
–> in Terminal Period, assume that co’s Discount Rate & CF Growth Rate stay the same
–> But, CF keeps changing: Unlevered FCF in Y1 of Terminal Period ==> project UFCF 1 year AFTER explicit forecast period (usually = (1 + Terminal UFCF Growth Rate) * Last UFCF in forecast period))
==> Terminal Value = Final Forecast Year UFCF * (1 + Terminal UFCF Growth Rate) / (Discount Rate - Terminal UFCF Growth Rate)
*Intuition:
- growth (on the CFs) increases returns, so increases what you can “afford” to pay NOW & still get the return you require
–> the higher the expected GROWTH, the more you can pay up front.
- if expected growth is the same as the required return, theoretically you can pay an infinite amount to achieve that return
Terminal UFCF Growth Rate
- Should be LOW - below long-term GDP growth rate of country (and perhaps in-line w/ rate of inflation)
- Even if co grows at a higher rate initially –> growth always slows down over time.
=> Should be fairly close to UFCF growth rate at the end of explicit forecast period
Terminal UFCF Growth Rate: Developed vs. Emerging Markets
- In developed/mature markets (ex: U.S., U.K., Canada) –> should use %s in low single digits (1-3%)
- In emerging markets (ex: China, India) –> still shouldn’t use a dramatically higher number
(B/c: even if market is growing aggressively right now, 1) rate will decrease eventually and 2) individual co’s will grow at lower rates in the long-term)
Multiples Method - what is it? how to calculate? flaw?
Way to calculate Terminal Value:
Terminal Value = Terminal EBITDA or EBIT or NOPAT or UFCF Multiple * Relevant Metric
- apply exit multiple to co’s last year of the forecast period’s EBITDA, EBIT or FCF
*flaw = median multiples can change in next 5-10 years -> may not be accurate by end of period
Multiples Method: Terminal Multiple - how to pick?
- Base on multiples of publicly traded co’s
- BUT: Sometimes apply a DISCOUNT - b/c as co’s growth rates slow over time –> multiples also tend to decrease
–> BUT BUT: For CYCLICAL industries –> valuation multiples tend to increase/decrease over time
==> (-) Tricky to pick “correct” Terminal Multiples
(Recommend: start w/ Perpetuity Growth Method & use Implied Multiple to check => Look at implications for Terminal Growth Rate)
Ex: If Terminal Growth Rate too high –> need to pick a lower multiple so that implied Growth Rate makes sense
Multiples Method vs. Gordon Growth Method - which to use?
- (-) both are difficult to determine precisely
- easier to get data for multiples method
- cyclical industry or multiples harder to predict (believe multiples will change significantly in several years) or no comparable companies –> gordon growth
- multiples easier to predict –> multiples method
Multiples Method: How to back into Implied Growth Rate?
Implied Terminal FCF Growth Rate = (Terminal Value * Discount Rate - Final Year FCF) / (Terminal Value + Final Year FCF)
Discounting Terminal Value to PV: How & Why?
- Terminal Value = co’s PV of its FCFs from end of forecast period onward into infinity, AS OF the final year
- BUT: trying to calculate what the co is worth TODAY
==> If discount rate stays the same each year, use standard PV formula
Implied TEV in Unlevered DCF Analysis
= PV of Terminal Value + PV of UFCFs
–> Compare to Co’s Current TEV
BUT: for public co’s & many private cos –> useful to go a step further => Calculate Implied EqV & Implied Share Price
Why? - 1) All valuation methodologies are about valuing Co’s Equity (Debt, Pref Stock, other sources = all easier to value); and 2) If FCF projections include unusual items –> can capture impact w/ Implied Share Price metric
How to calculate Implied EqV & Implied Share Price from Implied TEV?
TEV to EqV:
1) Add non-operating assets
2) Subtract Liability & Equity Items that represent investor groups outside common SHs
= EqV
NOTE: Do not double-count items
- If you DEDUCT an expense w/in FCF => ignore corresponding L&E item in bridge
- If you EXCLUDE or ADD BACK an expense w/in FCF => subtract corresponding L&E item in bridge
Implied Share Price = Implied EqV / Diluted Share count
DCF: Why sensitize? How to sensitize?
(+) of DCF: easier to examine range of possible outcomes –> Want to look at full range of possibilities in investing
- 2 methods: 1) Scenarios and 2) Sensitivities
Sensitivities = useful when assumptions/drivers don’t necessarily correlate w/ each other
==> In most DCF analysis: sensitive Discount Rate vs. Terminal Growth Rate or Terminal Multiples (b/c they both make a huge impact)
Walk me through how to use precedent transactions & public comps
1) select universe of (comparable) companies & precedent transactions based on certain criteria & metrics
2) determine relevant financial metrics & multiples for each (ex: EBITDA, revenue) & calculate them for each co & transaction.
3) determine the range of valuation multiples for each set: 25th percentile, median, 75th percentile; low & high
5) apply those multiples to the (corresponding) financial metrics of the co you are currently valuing in order to determine range of the co’s implied value(s). do that for all multiples
Public Comps - selecting comps & intuition
main criteria:
1. industry
2. geography
3. financial criteria (ex: indicating size size - revenue; ebitda)
*intuition: want to select co’s with similar DISCOUNT RATES & CFs.
–> if co’s are truly comparable, should have similar discount rates & CFs
- same industry -> subject to same risk factors = should theoretically have similar range of discount rates
-similar financial metrics (ex: revenue) = should theoretically have similar CFs
=> diffs in CF growth rate should explain diffs in the multiples
- look at growth rates of various metrics & corresponding multiples to see how your co is currently price
Precedent Transactions - selecting comps
main criteria:
1. industry
2. geography
3. financial criteria (ex: indicating size size - revenue; ebitda)
for precedent transactions: also consider
- TIMING
- financial criteria = based on TRANSACTION VALUE; purchase price at the time deal was announcement (Purchase EqV –> bridge to TEV, rather than EBITDA, revenue, etc)
Precedent Transactions - metrics/multiples
- sales-based & profitability-based metrics/multiples
- HISTORICAL metrics/multiples
(ex: LTM Revenue, LTM EBITDA)
*b/c: difficult to find projections for acquired companies at the time they were acquired
Public Comps - metrics/multiples
DCF - when is it useful vs. not?
useful for:
- mature cos w/ stable, predictible CFs -> future assumptions would be more accurate
not useful for:
- fast-growing, unpredictible co’s (ex: in unproven markets), unstable CFs -> future assumptions may not hold up
- co’s w/ no profit and/or revenue -> can’t predict CFs
- exs: tech start-ups
or
- co’s where debt & operating assets & Ls serve v diff roles
(ex: banks; insurance firms)
Other valuation methodologies?
- sum of the parts: separate each part of co into diff parts –> value them separately & add them together
- liquidation valuation: BV of assets - BV of Ls => how much eq investors would receive (if co was liquidated)
- M&A premiums: look at premiums paid for the co in past M&A transactions
- LBO analysis: minimum that PE firm could pay to reach a certain level of IRR
- future share price analysis: use P/E multiples of comparable co’s to PROJECT out co’s future share price & DISCOUNT it back to present value
Liquidation Valuation - what is it? when is it useful? when would it produce highest value?
- BV of assets - BV of Ls ==> how much eq investors would get
useful in:
- bankruptcy scenarios - would investors get anything after paying off Ls?
- advising co’s re whether it’s better to sell off 100% of their co or sell of assets separately
- would produce highest value if: disconnect bt book value & market value
–> co had substantial hard assets that market was undervaluing (ex: b/c of earnings miss; cyclicality)
Sum of the Parts Valuation - what is it? when is it useful?
- separate each part of co into diff parts
–> value them separately using diff sets of comps & precedent transactions ==> add them together
useful when:
- co has diff, unrelated divisions
(ex: conglomerate like GE)
LBO analysis - what is it? when to use?
- minimum (SET THE FLOOR) that PE firm would pay to reach a certain level of IRR
useful when:
- PE buyer & LBO
- strategic buyers also use when competing w/ financial sponsors for a co -> see what a PE buyer would pay
