Valuation - Basic

Question 1

What are the 3 major valuation methodologies?

Answer 1

• Comparable Companies
• Precedent Transactions
• Discounted Cash Flow Analysis

Question 2

Rank the 3 valuation methodologies from highest to lowest expected value.

Answer 2

Trick question – there is no ranking that always holds. In general, Precedent Transactions will be higher than Comparable Companies due to the Control Premium built into acquisitions.

Beyond that, a DCF could go either way and it’s best to say that it’s more variable than other methodologies. Often it produces the highest value, but it can produce the lowest value as well depending on your assumptions.

Question 3

When would you not use a DCF in a Valuation?

Answer 3

You do not use a DCF if the company has unstable or unpredictable cash flows (tech or biotech startup) or when debt and working capital serve a fundamentally different role. For example, banks and financial institutions do not re-invest debt and working capital is a huge part of their Balance Sheets – so you wouldn’t use a DCF for such companies.

Question 4

What other Valuation methodologies are there?

Answer 4

• Liquidation Valuation – Valuing a company’s assets, assuming they are sold off and then subtracting liabilities to determine how much capital, if any, equity investors receive
• Replacement Value – Valuing a company based on the cost of replacing its assets
• LBO Analysis – Determining how much a PE firm could pay for a company to hit a “target” IRR, usually in the 20-25% range
• Sum of the Parts – Valuing each division of a company separately and adding them together at the end
• M&A Premiums Analysis – Analyzing M&A deals and figuring out the premium that each buyer paid, and using this to establish what your company is worth
• Future Share Price Analysis – Projecting a company’s share price based on the P / E multiples of the public company comparables, then discounting it back to its present value

Question 5

When would you use a Liquidation Valuation?

Answer 5

This is most common in bankruptcy scenarios and is used to see whether equity shareholders will receive any capital after the company’s debts have been paid off. It is often used to advise struggling businesses on whether it’s better to sell off assets separately or to try and sell the entire company.

Question 6

When would you use Sum of the Parts?

Answer 6

This is most often used when a company has completely different, unrelated divisions – a conglomerate like General Electric, for example.

If you have a plastics division, a TV and entertainment division, an energy division, a consumer financing division and a technology division, you should not use the same set of Comparable Companies and Precedent Transactions for the entire company.

Instead, you should use different sets for each division, value each one separately, and then add them together to get the Combined Value.

Question 7

When do you use an LBO Analysis as part of your Valuation?

Answer 7

Obviously you use this whenever you’re looking at a Leveraged Buyout – but it is also used to establish how much a private equity firm could pay, which is usually lower than what companies will pay.

It is often used to set a “floor” on a possible Valuation for the company you’re looking at.

Question 8

What are the most common multiples used in Valuation?

Answer 8

• Enterprise Value / Revenue: How valuable is a company in relation to its overall sales.
• Enterprise Value / EBITDA: How valuable is a company in relation to its approximate cash flow.
• Enterprise Value / EBIT: How valuable is a company in relation to the pre-tax profit it earns from its core business operations.
• Price Per Share / Earnings Per Share (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.

Other multiples include Price Per Share / Book Value Per Share (P / BV), Enterprise Value / Unlevered FCF, and Equity Value / Levered FCF.

P / BV is not terribly meaningful for most companies; EV / Unlevered FCF is closer to true cash flow than EV / EBITDA but takes more work to calculate; and Equity Value / Levered FCF is even closer, but it’s influenced by the company’s capital structure and takes even more time to calculate.

Question 9

What are some examples of industry-specific multiples?

Answer 9

Technology (Internet): EV / Unique Visitors, EV / Pageviews

Retail / Airlines: EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rent)

Energy: P / MCFE, P / MCFE / D (MCFE = 1 Million Cubic Foot Equivalent, MCFE/D = MCFE per Day), P / NAV (Share Price / Net Asset Value)

Real Estate Investment Trusts (REITs): Price / FFO, Price / AFFO (Funds From Operations, Adjusted Funds From Operations)

Technology and Energy should be straightforward – you’re looking at traffic and energy reserves as value drivers rather than revenue or profit.

For Retail / Airlines, you often remove Rent because it is a major expense and one that varies significantly between different types of companies.

For REITs, Funds From Operations is a common metric that adds back Depreciation and subtracts gains on the sale of property. Depreciation is a non-cash yet extremely large expense in real estate, and gains on sales of properties are assumed to be non-recurring, so FFO is viewed as a “normalized” picture of the cash flow the REIT is generating.

Question 10

When you’re looking at an industry-specific multiple like EV / Scientists or EV / Subscribers, why do you use Enterprise Value rather than Equity Value?

Answer 10

You use Enterprise Value because those scientists or subscribers are “available” to all the investors (both debt and equity) in a company. The same logic doesn’t apply to everything, though – you need to think through the multiple and see which investors the particular metric is “available” to.

Question 11

Would an LBO or DCF give a higher valuation?

Answer 11

Technically it could go either way, but in most cases the LBO will give you a lower valuation.

Here’s the easiest way to think about it: with an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year – you’re only valuing it based on its terminal value.

With a DCF, by contrast, you’re taking into account both the company’s cash flows in between and its terminal value, so values tend to be higher.

Note: Unlike a DCF, an LBO model by itself does not give a specific valuation. Instead, you set a desired IRR and determine how much you could pay for the company (the valuation) based on that.

Question 12

How would you present these Valuation methodologies to a company or its investors?

Answer 12

Usually you use a “football field” chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number.

Question 13

How would you value an apple tree?

Answer 13

The same way you would value a company: by looking at what comparable apple trees are worth (relative valuation) and the value of the apple tree’s cash flows (intrinsic valuation).

Yes, you could do a DCF for anything – even an apple tree.

Question 14

Why can’t you use Equity Value / EBITDA as a multiple rather than Enterprise Value / EBITDA?

Answer 14

EBITDA is available to all investors in the company – rather than just equity holders. Similarly, Enterprise Value is also available to all shareholders so it makes sense to pair them together.

Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect the company’s entire capital structure – only the part available to equity investors.

Question 15

When would a Liquidation Valuation produce the highest value?

Answer 15

This is highly unusual, but it could happen if a company had substantial hard assets but the market was severely undervaluing it for a specific reason (such as an earnings miss or cyclicality).

As a result, the company’s Comparable Companies and Precedent Transactions would likely produce lower values as well – and if its assets were valued highly enough, Liquidation Valuation might give a higher value than other methodologies.

Question 16

Let’s go back to 2004 and look at Facebook back when it had no profit and no revenue. How would you value it?

Answer 16

You would use Comparable Companies and Precedent Transactions and look at more “creative” multiples such as EV/Unique Visitors and EV/Pageviews rather than EV/Revenue or EV/EBITDA.

You would not use a “far in the future DCF” because you can’t reasonably predict cash flows for a company that is not even making money yet.

This is a very common wrong answer given by interviewees. When you can’t predict cash flow, use other metrics – don’t try to predict cash flow anyway!

Question 17

What would you use in conjunction with Free Cash Flow multiples – Equity Value or Enterprise Value?

Answer 17

Trick question. For Unlevered Free Cash Flow, you would use Enterprise Value, but for Levered Free Cash Flow you would use Equity Value.

Remember, Unlevered Free Cash Flow excludes Interest and thus represents money available to all investors, whereas Levered already includes Interest and the money is therefore only available to equity investors.

Debt investors have already “been paid” with the interest payments they received.

Question 18

You never use Equity Value / EBITDA, but are there any cases where you might use Equity Value / Revenue?

Answer 18

Never say never. It’s very rare to see this, but sometimes large financial institutions with big cash balances have negative Enterprise Values – so you might use Equity Value
/ Revenue instead.

You might see Equity Value / Revenue if you’ve listed a set of financial and non- financial companies on a slide, you’re showing Revenue multiples for the non-financial companies, and you want to show something similar for the financials.

Note, however, that in most cases you would be using other multiples such as P/E and P/BV with banks anyway.

Question 19

How do you select Comparable Companies / Precedent Transactions?

Answer 19

The 3 main ways to select companies and transactions:

1. Industry classification
2. Financial criteria (Revenue, EBITDA, etc.)
3. Geography

For Precedent Transactions, you often limit the set based on date and only look at transactions within the past 1-2 years.

The most important factor is industry – that is always used to screen for companies/transactions, and the rest may or may not be used depending on how specific you want to be.

Here are a few examples:

Comparable Company Screen: Oil & gas producers with market caps over $5 billion

Comparable Company Screen: Digital media companies with over $100 million in revenue

Precedent Transaction Screen: Airline M&A transactions over the past 2 years involving sellers with over $1 billion in revenue

Precedent Transaction Screen: Retail M&A transactions over the past year

Question 20

How do you apply the 3 valuation methodologies to actually get a value for the company you’re looking at?

Answer 20

Sometimes this simple fact gets lost in discussion of Valuation methodologies. You take the median multiple of a set of companies or transactions, and then multiply it by the relevant metric from the company you’re valuing.

Example: If the median EBITDA multiple from your set of Precedent Transactions is 8x and your company’s EBITDA is $500 million, the implied Enterprise Value would be $4 billion.

To get the “football field” valuation graph you often see, you look at the minimum, maximum, 25th percentile and 75th percentile in each set as well and create a range of values based on each methodology.

Question 21

What do you actually use a valuation for?

Answer 21

Usually you use it in pitch books and in client presentations when you’re providing updates and telling them what they should expect for their own valuation.

It’s also used right before a deal closes in a Fairness Opinion, a document a bank creates that “proves” the value their client is paying or receiving is “fair” from a financial point of view.

Valuations can also be used in defense analyses, merger models, LBO models, DCFs (because terminal multiples are based off of comps), and pretty much anything else in finance.

Question 22

Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium?

Answer 22

This could happen for a number of reasons:

• The company has just reported earnings well-above expectations and its stock price has risen recently.
• It has some type of competitive advantage not reflected in its financials, such as a key patent or other intellectual property.
• It has just won a favorable ruling in a major lawsuit.
• It is the market leader in an industry and has greater market share than its competitors.

Question 23

What are the flaws with public company comparables?

Answer 23

• 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.

Question 24

How do you take into account a company’s competitive advantage in a valuation?

Answer 24

1. Look at the 75th percentile or higher for the multiples rather than the Medians.
2. Add in a premium to some of the multiples.
3. Use more aggressive projections for the company.

In practice you rarely do all of the above – these are just possibilities.

Question 25

Do you ALWAYS use the median multiple of a set of public company comparables or precedent transactions?

Answer 25

There’s no “rule” that you have to do this, but in most cases you do because you want to use values from the middle range of the set. But if the company you’re valuing is distressed, is not performing well, or is at a competitive disadvantage, you might use the 25th percentile or something in the lower range instead – and vice versa if it’s doing well.

Question 26

You mentioned that Precedent Transactions usually produce a higher value than Comparable Companies – can you think of a situation where this is not the case?

Answer 26

Sometimes this happens when there is a substantial mismatch between the M&A market and the public market. For example, no public companies have been acquired recently but there have been a lot of small private companies acquired at extremely low valuations.

For the most part this generalization is true but keep in mind that there are exceptions to almost every “rule” in finance.

Question 27

What are some flaws with precedent transactions?

Answer 27

• Past transactions are rarely 100% comparable – the transaction structure, size of the company, and market sentiment all have huge effects.
• Data on precedent transactions is generally more difficult to find than it is for public company comparables, especially for acquisitions of small private companies.

Question 28

Two companies have the exact same financial profile and are bought by the same acquirer, but the EBITDA multiple for one transaction is twice the multiple of the other transaction – how could this happen?

Answer 28

Possible reasons:

1. One process was more competitive and had a lot more companies bidding on the target.
2. One company had recent bad news or a depressed stock price so it was acquired at a discount.
3. They were in industries with different median multiples.

Question 29

Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?

Answer 29

Warren Buffett once famously said, “Does management think the tooth fairy pays for capital expenditures?”

He dislikes EBITDA because it excludes the often sizable Capital Expenditures companies make and hides how much cash they are actually using to finance their operations.

In some industries there is also a large gap between EBIT and EBITDA – anything that is very capital-intensive, for example, will show a big disparity.

Question 29

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?

Answer 29

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, financial institutions, and other companies where interest payments / expenses are critical.

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).

Question 30

If you were buying a vending machine business, would you pay a higher multiple for a business where you owned the machines and they depreciated normally, or one in which you leased the machines? The cost of depreciation and lease are the same dollar amounts and everything else is held constant.

Answer 30

You would pay more for the one where you lease the machines. Enterprise Value would be the same for both companies, but with the depreciated situation the charge is not reflected in EBITDA – so EBITDA is higher, and the EV / EBITDA multiple is lower as a result. For the leased situation, the lease would show up in SG&A so it would be reflected in EBITDA, making EBITDA lower and the EV / EBITDA multiple higher.

Question 30

How do you value a private company?

Answer 30

You use the same methodologies as with public companies: public company comparables, precedent transactions, and DCF. But there are some differences:

• You might apply a 10-15% (or more) discount to the public company comparable multiples because the private company you’re valuing is not as “liquid” as the public comps.
• You can’t use a premiums analysis or future share price analysis because a private company doesn’t have a share price.
• Your valuation shows the Enterprise Value for the company as opposed to the implied per-share price as with public companies.
• A DCF gets tricky because a private company doesn’t have a market capitalization or Beta – you would probably just estimate WACC based on the public comps’ WACC rather than trying to calculate it.

Question 31

Let’s say we’re valuing a private company. Why might we discount the public company comparable multiples but not the precedent transaction multiples?

Answer 31

There’s no discount because with precedent transactions, you’re acquiring the entire company – and once it’s acquired, the shares immediately become illiquid.

But shares – the ability to buy individual “pieces” of a company rather than the whole thing – can be either liquid (if it’s public) or illiquid (if it’s private).

Since shares of public companies are always more liquid, you would discount public company comparable multiples to account for this.

Question 32

Can you use private companies as part of your valuation?

Answer 32

Only in the context of precedent transactions – it would make no sense to include them for public company comparables or as part of the Cost of Equity / WACC calculation in a DCF because they are not public and therefore have no values for market cap or Beta.

Question 33

For Public Comps, you calculate Equity Value and Enterprise Value for use in multiples based on companies’ share prices and share counts… but what about for Precedent Transactions? How do you calculate multiples there?

Answer 33

They should be based on the purchase price of the company at the time of the deal announcement.

For example, a seller’s current share price is $40.00 and it has 10 million shares outstanding. The buyer announces that it will pay $50.00 per share for the seller.

The seller’s Equity Value in this case, in the context of the transaction, would be $50.00 * 10 million shares, or $500 million. And then you would calculate its Enterprise Value the normal way: subtract cash, add debt, and so on.

You only care about what the offer price was at the initial deal announcement. You never look at the company’s value prior to the deal being announced.

Question 34

Can you walk me through how to calculate EBIT and EBITDA? How are they different?

Answer 34

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.

EBITDA is defined as EBIT plus Depreciation plus Amortization. You may sometimes add back other expenses as well.

The idea of EBITDA is to move closer to a company’s “cash flow,” since D&A are both non-cash expenses… but there’s a problem with that since you’re also excluding CapEx altogether.

Question 35

What about how you calculate Unlevered FCF (Free Cash Flow to Firm) and Levered FCF (Free Cash Flow to Equity)?

Answer 35

There are several methods, 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.

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.

Question 36

How are the key operating metrics and valuation multiples correlated? In other words, what might explain a higher or lower EV / EBITDA multiple?

Answer 36

Usually, there is a correlation between growth and valuation multiples. So if one company is growing revenue or EBITDA more quickly, its multiples for both of those may be higher as well.

However, math also plays a role and sometimes companies with extremely high EBITDA margins (for example) may have lower EBITDA multiples because EBITDA itself is much higher to begin with… and it’s in the denominator.

Finally, keep in mind that plenty of other non-financial factors explain higher or lower multiples.

Question 37

Why can’t you use Equity Value / EBITDA as a multiple rather than Enterprise Value / EBITDA?

Answer 37

If the metric includes interest income and expense, you use Equity Value; if it excludes them (or is “before” them), you use Enterprise Value.

EBITDA is available to all investors in the company – not just common shareholders. Similarly, Enterprise Value is also available to all investors since it includes Equity and Debt, so you pair them together.

Calculating Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect the company’s entire capital structure – only what’s available to common shareholders.

Question 38

What are some problems with EBITDA and EBITDA multiple? And if there are so many problems, why do we still use it?

Answer 38

First, it hides the 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; it also hides CapEx spending, which can also be huge.

EBITDA also ignores working capital requirements (e.g. Accounts Receivable, Inventory, Accounts Payable), which can be very large for some companies.

Finally, companies like to “add back” many charges and expenses to EBITDA, so you never really know what it represents unless you dig into it in-depth.

So in many cases, EBITDA is not even close to true “cash flow” – it is widely used mostly because of convenience (it’s easy to calculate) and because it has become a standard over time.

Another argument for EBITDA is that although it’s not close to 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.

Question 39

Could EV / EBITDA ever be higher than EV / EBIT for the same company?

Answer 39

No. By definition, EBITDA must be greater than or equal to EBIT because to calculate it, you take EBIT and then add Depreciation & Amortization, neither of which can be negative (they could, however, be $0, at least theoretically).

Since EBITDA is always greater than or equal to EBIT, EV / EBITDA must always be less than or equal to EV / EBIT for a single company.

Question 40

Why are Public Comps and Precedent Transactions sometimes viewed as being “more reliable” than a DCF?

Answer 40

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).

Also note that sometimes you don’t have good or truly comparable data for these, in which case a DCF may produce better results.

Question 41

The S&P 500 Index (or equivalent index in other country) has a median P / E multiple of 20x. A manufacturing company you’re analyzing has earnings of $1 million. How much is the company worth?

Answer 41

It depends on how it’s performing relative to the index, and relative to companies in its own industry. If it has higher growth and/or higher margins, you may assign a higher multiple to it – maybe 25x or even 30x, and therefore assume that its Equity Value equals $25 million or $30 million.

If it’s on par with everyone else, then maybe its valuation is just $20 million. And if it’s underperforming, perhaps it’s lower than that.

Qualitative factors, such as management team and market position, also come into play and may determine the appropriate multiple to use.

Question 42

A company’s current stock price is $20.00 per share, and its P / E multiple is 20x, so its EPS is $1.00. It has 10 million shares outstanding.

Now it does a 2-for-1 stock split – how do its P / E multiple and valuation change?

Answer 42

They don’t. Think about what happens: the company now has 20 million shares outstanding… but its Equity Value has stayed the same, so its share price falls to $10.00.

Its EPS falls to $0.50, but its share price has also fallen to $10.00, so the P / E multiple remains 20x.

Splitting stock into fewer units or additional units doesn’t, by itself, make a company worth more or less.

However, in practice, often a stock split is viewed as a positive sign by the market… so in many cases a company’s value will go up and its share price won’t necessarily be cut in half, so P / E could increase.

Question 43

Let’s say that you’re comparing a company with a strong brand name, such as Coca-Cola, to a generic manufacturing or transportation company.

Both companies have similar growth profiles and margins. Which one will have the higher EV / EBITDA multiple?

Answer 43

In all likelihood, Coca-Cola will have the higher multiple due to its strong brand name.

Remember that valuation is not a science – it’s an art, and the market often behaves in irrational ways. Values are not based strictly on financial criteria, and other factors such as brand name, perceived “trendiness,” and so on all make a huge impact.