Intro-to-Valuation

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Introduction to Valuation
Why Valuation?
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Most important concept in Investment Banking
Determining how much a company is worth
Why do we need this?
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M&A (how much should I pay for target?)
Equity (pricing shares)
Debt (maximum debt capacity)
Valuation
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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
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Numerator= Measure of value
Denominator= Operating Statistic
Examples:
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P/E (What is this multiple really?)
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Market Cap/Net Income
More commonly used on Wall Street are EV multiples
(EV/EBITDA)
Aside: Why is EV/NI not used?
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EV flows to both debt and equity holders, NI flows only to
equity holders
EV/EBITDA
Break Down EV/EBITDA
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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
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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?
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$1,000,000
Example Cont.
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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.
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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.
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Market Cap= $1,000,000
Add $1,000,000 in debt
Subtract $500,000 in cash
FV= $1,500,000
What is EBITDA?
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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?
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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
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Reflects current valuation
Can be affected by market conditions and sentiment
Also called Public Market Comps
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You can only perform this with Public Companies due to the
amount of information needed
Step 1: Select Your Universe
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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
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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
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‘Spreading’
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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?
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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
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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
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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
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I found that the average EV/EBITDA for my comps is 10x
I know my financial statistics, EBITDA = $500,000
What is my EV?
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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
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Pros
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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
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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
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Similar to Comps
Looks at multiples paid for comparable companies in past
M&A deals
Will always give you the highest valuation, why?
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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
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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
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I now need financial information for the M&A activity
Proxy statements, 8K, 10K/Q
Step 3: Spreading
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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
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Pros
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Objective, I’m not making assumptions
Market-based, based on what companies actually paid for
similar companies
Cons
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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
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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
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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.
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Why 5 years?  by this time the company is deemed to
have reached a ‘steady state’
Formula:
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EBIT * (1-Tax Rate)
+ D&A
-Δ Net Working Capital
-Capex
= Unlevered Free Cash Flow
Step 2: WACC
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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.
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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.
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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?
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Interest paid is often tax deductible
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What happens after year 5, does the company cease to
exist?
No, use Terminal Value
Step 3: Terminal Value (Perp Method)
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This will give us the value of all future FCF for the
company beyond those 5 years
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How many years is this projecting out?
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10, we use the final years FCF as a starting point
We know WACC too, but what is g?
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Perpetuity growth rate= long-term growth rate usually b/t 2 %
and 4%
Step 4
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Set up your formula, input your numbers
Discount each cash flow for the 5 years, sum this, and add
it to you TV calculation
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This number is equal to your company’s Firm Value
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Pros and Cons
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Pros
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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
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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?
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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
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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
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Investopedia.com
Investment Banking by Josh Rosenbaum and Josh Pearl
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