Investment Banking - Valuation Questions and answers

Investment Banking - Valuation Questions and answers What are the 3 major valuation methodologies? Public comps, precedent transactions, and the DCF. Public comps and precedent transactions are examples of relative valuation, and the DCF is an example of intrinsic valuation. Can you walk me through how to use public comps and precedents transactions? First, you select the companies and transactions based on criteria such as industry, financial metrics, and geography. Then you determine the appropriate metrics and multiples for each set and calculate them for all the companies and transactions. Next, you calculate the minimum, 25th percentile, median, 75th percentile, and maximum for each valuation multiple in the set. Finally you apply those numbers to the financial metrics for the company you're analyzing to estimate the potential range for its valuation. How do you select comparable companies or precedent transactions? The three main criteria are: industry classification, financial criteria (revenue, EBITDA), and geography. For precedent transactions you also limit based on date and often focus on transactions within the last 1-2 years. How do you calculate multiples for precedent transactions? They should be based on the purchase price of the company at the time of the deal announcement. How would you value an apple tree? The same way you would value a company: by looking at what comparable apple trees are worth (relative valuation) and the present value of the apple tree's cash flows (intrinsic valuation). When is a DCF useful? A DCF is useful when a company is large, mature, and has stable and predictable cash flows. Your far-in-the-future assumptions will generally be more accurate with these companies. A DCF is not as useful if the company has unpredictable or unstable cash flows or when debt and operating assets and liabilities serve fundamentally different roles. What other valuation methodologies are there? Liquidation valuation, LBO analysis, sum of parts, M&A premiums analysis, future share price analysis When is a liquidation valuation useful? It is most common in bankruptcy scenarios and is used to see whether or not shareholders will receive anything after the company's liabilities have been paid off with the proceeds to selling all of its assets. It is often used to advice struggling businesses on whether it's better to sell of assets separately or to sell 100% of the company. When would you use a sum of parts valuation? When a company has completely different, unrelated divisions - a conglomerate like GE. For companies like this, they are very unique so there are not a lot of comps. When would you use an LBO analysis as part of your valuation? When you are doing an LBO, but it is also useful for setting a floor on the company's value and determining the minimum amount a PE firm could pay to achieve its targeted returns. You often see it when strategic investors and financial sponsors are competing to buy the same company, and you want to determine the potential price if a PE firm were to acquire the company. How do you apply the valuation methodologies to value a company? You would present everything in a football field graph. To do this you calculate the percentiles and multiply by the relevant metrics for the company you're analyzing. What's the difference between EBIT and EBITDA? EBIT is just a company's operating income on its income statement - it includes not only COGS and operating expenses, but also non-cash charge such as depreciation and amortization and therefore reflects, at least indirectly, the company's CapEx. EBITDA is defined as EBIT plus depreciation plus amortization. The idea of EBITDA is to move closer to a company's cash flow, since D&A are both non-cash expenses. The biggest problem with EBITDA is that you're excluding CapEx altogether. How do you calculated unlevered FCF? Unlevered FCF=EBIT x (1-tax rate) + non-cash charges - change in operating assets and liabilities - CapEx With unlevered FCF, you're excluding interest income and expenses and mandatory debt repayments. How do you calculate levered FCF? Levered FCF=net income + non-cash charges - changes 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 What are the most common valuation multiples and what do they mean? EV/Revenue: how valuable a company is in relation to its overall sales EV/EBITDA: how valuable a company is in relation to its approximate cash flow EV/EBIT: how valuable a company is in relation to the pre-tax profit it earns from its core business operations P/E: how valuable a company is in relation to its after-tax profits, inclusive of interest income and expense and other non-core business activities How are the key operating metrics and valuation multiples correlated? Usually there is a correlation between growth and valuation multiples. 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 may have lower EBITDA multiples because EBITDA itself is much higher to begin with and it is in the denominator. Why can't you use equity value/EBITDA as a multiple rather than EV/EBITDA? If the metric includes interest income and expense then you use equity value, but if it excludes these you use enterprise value. EBITDA excludes interest income and expense - it is available to all investors in the company. Why does Warren Buffet prefer EBIT multiples to EBITDA multiples? EBITDA multiples hide CapEx and disguises how much cash a company needs to finance its operations. In some industries there is also a large gap between EBIT and EBITDA - anything that is capital-intensive and asset-heavy. Note: EBIT does not include CapEx but does include depreciation. If a company has high depreciation expenses, chances are it has high CapEx spending as well. What are some problems with EBITDA and EBITDA multiples? They hid the amount of debt principal and interest that a company is pay each year, which can be very large and may make the company cash flow negative. It also hides CapEx spending, which is huge. EBITDA also ignores working capital requirements (AR, inventory, AP), 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 means unless you dig into it - so in many cases EBITDA is not even close to true cash flow, just used because its convenient. Mostly use it because it is more about comparability than cash flow approximation. What is the difference between the EV/EBIT, EV/EBITDA, and P/E multiples? P/E depends on the company's capital structure, whereas the other two are capital-structure neutral. Therefore, you use P/E for banks, insurance firms, and other companies where interest is critical and where capital structures tend to be similar. EV/EBIT includes D&A so you use it in industries where D&A is large and CapEx and fixed assets are important - manufacturing. EV/EBITDA excludes D&A, so you use it in industries where fixed assets are less important and where D&A is comparatively smaller - internet companies. Could EV/EBITDA ever be higher than EV/EBIT for the same company? No. By definition, EBITDA must be greater than or equal to EBIT because to calculate it you add D&A to EBIT, and D&A can't be negative. Since EBITA is always greater than or equal to EBIT, EV/EBITDA must always be less than or equal to EV/EBIT for the same company. What are some examples of industry specific multiples? Tech: EV/Unique visitors, EV/Pageviews Retail/airlines: EV/EBITDAR (earnings before interest, taxes, D&A, rental expenses) Oil&gas: EV/EBITDAX (earnings before interest, taxes, D&A, and rental expenses), EV/Production, EV/Proved reserves Real estate investment trusts: Price/FFO per share, Price/AFFO per share, (funds from operations, adjusted funds from operations) Rank the 3 main valuation methodologies from highest to lowest expected value There is no ranking that always holds up, but in general precedent transactions will be higher than comparable public companies due to the control premium built into acquisitions (the buyer must pay a premium over the company's current share price to acquire it). 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. Would an LBO or DCF produce higher valuation? In most cases an LBO would give you a lower valuation. With an LBO, you don't get any value from the cash flows of a company in between year 1 and the final year - you only get value out of its final year. With a DCF, you're taking into account both the company's cash flows in the period itself and its terminal value, so values tend to be higher. When would a liquidation valuation produce the highest value? Highly unusual, but could happen if a company had substantial hard assets the the market was severely undervaluing it for a specific reason, such as an earnings miss or cyclicality. As a result, the comps and precedents would likely produce lower values as well - and if assets were valued highly enough, liquidation valuation could give you the highest value. Why are public comps and precedents sometimes viewed as more reliable than the DCF? Because they are based on actual market data, as opposed to assumptions far in the future. What are the flaws with public comps? 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. Can you think of a situation where a precedent transaction would produce a lower value than a comparable company? Sometimes this happens when there is substantial mismatch between the M&A market and the public markets. For example, no public companies have been acquired recently but lots of small private companies have been acquired at low valuations. What are some flaws with precedent transactions? Past transactions are rarely 100% comparable - the transaction structure, size of the company, and market sentiment all make a huge impact. Data on the precedent transactions is generally more difficult to find than it is for public company comparable, especially for acquisitions of small, private companies. How do you present these valuation methodologies to a company or its investors? Football field chart. Could use for pitch books or client presentations, parts of other models, fairness opinions Why would a company with similar growth and profitability to its other companies be valued at a premium? Good earnings season, high market share, other valuable property, favorable ruling in a major lawsuit How do you take into account a company's competitive advantage in a valuation? Highlight the 75th percentile or higher for the multiples rather than the median Add in a premium to some of the multiples Use more aggressive projections for the company No you always use the median multiple of a set of comps or precedents? No, you will always show a range. You could focus on the 25th or 75th percentile if the company is underperforming or outperforming for some reason. If you were buying a vending machine business, would you pay a higher EBITDA multiple for a business that owned their machines or one that leased them? You would pay a higher multiple for a company that leased them because the one who owns its machines' EBITDA would be higher and therefore the multiple would be lower. How would you value a company that has no profit or revenue? You could use comps and precedents and look at more unique multiples such as EV/Unique visitors You could use a far in the future DCF and project a company's financials out until it actually earns a revenue and profit