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Introduction to Valuation

Why Valuation? Most important concept in Investment

Banking Determining how much a company is worth Why do we need this?

M&A (how much should I pay for target?) Equity (pricing shares) Debt (maximum debt capacity)

Valuation This is not an exact science There is no ‘black box’ approach to valuation Depends greatly on banker’s judgments All valuations will be biased Cannot rely on just one method, each has its

flaws

Multiples Numerator= Measure of value Denominator= Operating Statistic Examples:

P/E (What is this multiple really?) Market Cap/Net Income

More commonly used on Wall Street are EV multiples (EV/EBITDA)

Aside: Why is EV/NI not used? EV flows to both debt and equity holders, NI flows

only to equity holders

EV/EBITDA

Break Down EV/EBITDA EV= Enterprise Value, commonly called Firm

Value Market Cap + Total Debt – Cash & Cash Equiv Think: How much money would be needed to

buy the whole company? EBITDA= Earnings Before Interest, Taxes,

Depreciation and Amortization

What is Firm Value? Example Company Acquirer wants to buy Company

Target Company Target sells at $10 per share They have 100,000 shares outstanding What is the Market Cap?

$1,000,000

Example Cont. But that’s not it, if A buys T they also take on

their debt This is going to increase the total price of the

purchase

Example Cont. But what about Cash? If T has Cash, A can use it to pay down some

of that Debt This is going to decrease the total price of the

purchase

Example Cont. Market Cap= $1,000,000 Add $1,000,000 in debt Subtract $500,000 in cash FV= $1,500,000

What is EBITDA? Metric to evaluate profitability Not GAAP, so there’s no legal requirements Strips out many expenses that may cloud

actual performance

EBITDA: What am I taking out and Why? Interest: It’s a function of management’s

financing choices Taxes: Can vary widely depending on prior

losses or acquisitions D&A: Subjective judgments like useful lives,

different methods Now it’s easier to compare companies

Comparable Companies Analysis

Comps Reflects current valuation Can be affected by market conditions and

sentiment Also called Public Market Comps

You can only perform this with Public Companies due to the amount of information needed

Step 1: Select Your Universe I am trying to value Company A As the name suggests, I need Comparable

Companies These are similar public companies, peers,

competitors Look for similar sectors/sub-sectors, products,

geography, size Realistically you also ask your Associate/VP,

they have immense sector and industry knowledge

Step 2: Get the Financial Information Once I have my Comparable Companies, Locate financial information What drives value? both past and future

performance Past Information- SEC filings, press releases Future Information- Research reports,

consensus

Step 3: Spread the Comps ‘Spreading’

Entering/Updating financial data and calculating statistics/ ratios/ trading multiples

Calculate valuation measures: Mkt Cap, Equity Value, Firm Value

And earnings measures: EBITDA, Net Income This is getting us to MULTIPLES

Why Can’t we just use Yahoo Finance or Something? Things like Mkt Cap and FV may be available there,

but You need to calculate earnings measures and

valuation measures from scratch (this means inputting #’s like revenue, interest, shares outstanding, etc.)

Allows for greater control and the ability to adjust just one piece

People are going to want to know how you got to that number and why it’s so low/high

You can’t trust it, they are often wrong or don’t take into account options/converts/one-time items

What if it’s in between reporting periods? Did I not sell anything in that time period?

If it were that easy, you wouldn’t have a job

Step 4: Benchmarking I calculated the financial stats, used some

Excel formulas to show my ratios and trading multiples

Now, which are the closest, most relevant comparables

Elimination of outliers, Creation of ranges for stats and multiples

Determine Valuation Trading multiples of the Comparable

Companies allow us to derive a value for the target

Apply the range of multiples to Company A

Some Simple Algebra I found that the average EV/EBITDA for my

comps is 10x I know my financial statistics, EBITDA =

$500,000 What is my EV?

EV/EBITDA=10x EV/$500,000=10x EV=$5,000,000

Note that I will often be using estimated forward financial stats and multiples

Pros and Cons Pros

Based on actual public market data, reflects market’s expectations

Can be updated based on day-to-day market data (What impact would a change in the price of a comp’s stock have?)

Cons Market based- What happens if there’s excessive

bearishness/a bubble? Relevant Comps may not exist Not an intrinsic valuation, not based on cash flow

Precedent Transactions Analysis

Precedents Similar to Comps Looks at multiples paid for comparable

companies in past M&A deals Will always give you the highest valuation,

why? If I am looking at what A paid for T 6 months ago,

A likely paid a premium for T. This is because A saw the opportunity for synergies and needed to pay more than the market price for T

Step 1: Universe This time I need a universe of similar

companies that have been bought recently I’m looking at targets, why wouldn’t I care

about buyers?

Step 2: Get the Info I now need financial information for the M&A

activity Proxy statements, 8K, 10K/Q

Step 3: Spreading Enter key financial data such as purchase

price, the target’s financial stats Use Excel to calculate multiples You’re going to end up with EV/EBITDA (or

comparable multiple) and use that to find your firm’s EV

Pros and Cons Pros

Objective, I’m not making assumptions Market-based, based on what companies actually

paid for similar companies Cons

These deals, by definition occurred in the past Hard to find comps, harder to find precedents Hard to find info on some transactions

Discounted Cash Flow Analysis

DCF The value of a company is derived from the

present value of its future cash flows What cash flows? Free Cash Flow How do I discount it to PV? WACC This is establishing an intrinsic value (as

opposed to market value)

Step 1: Project Free Cash Flow Projected for 5 years This is actually unlevered FCF Unlevered FCF= Cash that a company is able

to generate after laying out money to maintain/expand its asset base

This is the cash that could be paid out to lenders and investors

How do I grow FCF? use growth assumptions developed by historical performance and expected sales growth rates, margins, capex, etc.

Step 1 Cont. Why 5 years? by this time the company is

deemed to have reached a ‘steady state’ Formula:

EBIT * (1-Tax Rate) + D&A -Δ Net Working Capital -Capex = Unlevered Free Cash Flow

Step 2: WACC We know that Present Value= Future

Value/(1+i)n

So we have FV (the FCF), now what do we discount this by?

WACC= Weighted Average Cost of Capital

Step 2 Cont. Every company has a capital structure made

up of Debt and Equity Any investor in our company needs to be

compensated, how much depends on whether they are taking on the risk of owning equity or owning debt

What is the Cost of Equity? CAPM Cost of Debt? usually the current yield on

outstanding issues (it’s complex and it’s DCM’s job)

Step 2 Cont. So say rd =5% and re =10% My company’s cap structure is 70% debt and

30% equity Now we weight these WACC= (rd * (1-T) * % debt) + (re * % equity) What’s that tax rate doing?

Interest paid is often tax deductible

What happens after year 5, does the company cease to exist?

No, use Terminal Value

Step 3: Terminal Value (Perp Method) This will give us the value of all future FCF for

the company beyond those 5 years

How many years is this projecting out? 10, we use the final years FCF as a starting point

We know WACC too, but what is g? Perpetuity growth rate= long-term growth rate

usually b/t 2 % and 4%

Step 4 Set up your formula, input your numbers Discount each cash flow for the 5 years, sum

this, and add it to you TV calculation

This number is equal to your company’s Firm Value

Pros and Cons Pros

Insulated from the market Based on cash flows, a very fundamental and

intrinsic valuation Allows for flexibility (I can change factors

affecting FCF in future periods) Cons

Are your forecasts accurate? How much of my valuation is consumed by TV?

(it’s often ¾’s or more) Small changes lead to big differences

So What do you do Now? Combine Valuation Methods Think about which Method you feel is most

accurate You can combine and weight them to come

out with a number

How to Pretend that you’re a Banker Turn it Gray Blue=Input, Black=Calculation, Green=Link to

other sheet Center Across Selection Go back to the old Office Turn off your Excel Gridlines Unplug your Mouse Use Shortcuts Customize your Keyboard How quick are you?

Sources Investopedia.com Investment Banking by Josh Rosenbaum and

Josh Pearl