McGill Investment Club
September 10th 2014
Advanced Technical Workshop
Table of Contents
Advanced Technical Workshop
Section I: Refresher from Last Session
a)
DCF
b)
Comps
c)
Precedent Transactions
Section II: Corporate Structure Questions
Section III: Valuation Questions
Section IV: Accounting Questions
Section V: Stock Pitch
Section VI: Q&A
2
Section I
Refresher from Last Session
Refresher
Traditional Valuation Methodologies
Discounted Cash Flow
Precedent Transaction Analysis
Comparable Trading Analysis
• Value based on net present value of future cash flows (enterprise or
equity cash flows)
• Value based upon applying observed financial metrics from comparable
past transactions
• Value based upon applying observed current trading metrics of
comparable, public companies
4
Section I
a)
Discounted Cash Flow
Discount Cash Flow
Principles
“Value determined by calculating the present value of a stream of projected cash flows over a certain
period and a terminal value”
 Projected after-tax unlevered free cash flows
 Forecast period should be long enough so that business reaches a steady state by the end of period and incorporates a cycle (if a
cyclical industry)
 Typically 5 to 10 years
 Terminal value
 Value of perpetual cash flows following end of forecast
 Terminal year should best mirror company's normalized future steady state
 Discount rate
 Weighted average cost of capital (“WACC”)
 Depends on capital structure (typically weighted average cost of equity and debt)
 WACC should reflect optimal and sustainable capital structure and underlying estimate of business risk
Enterprise Value
• PV of
cumulative
cash flows to
all claim
holders
Unlevered Free
Cash Flow “UFCF”
• + EBIT*(1-tax)
• + Depreciation &
Amortization
• - Capital Expenditure
• - ∆ in Working Capital
Discounted Rate
• Weighted
Average Cost
of Capital
“WACC”
6
Discount Cash Flow
Terminal Value
“Determining the terminal value involves the application of one of the following going concern
approaches”
Practice
•
Comparable Trading / Transaction
Multiple
•
•
Perpetual Growth
•
•
Considerations
Based upon current trading
multiples ~ multiples of EBITDA
Based upon multiples paid in
comparable company
transactions
•
Single stage – constant growth
perpetuity
Unlevered Free Cash Flow * (1+
Perpetual Growth Rate) / (WACC
– Perpetual Growth Rate)
2 stage – growth rate 1 for n
years followed by growth rate 2
•
•
•
•
Industry or company
considerations may make the
current environment not
comparable to the terminal year
Implies a perpetual growth rate
from the terminal point onward
Ideal when company is in steady
state
Very sensitive to changes in
inputs, especially perpetual
growth rate assumptions
Implies multiples as if the
business was transacted in the
terminal year
7
Discount Cash Flow
Strengths & Limitations
Strengths
Limitations
 Based on well accepted corporate finance theory
 False perception attributed to sophisticated technique
due to inherent subjectivity in forecast, terminal value
and WACC
 Flexibility to handle different patterns of cash inflows and
outflows
 Recognizes time value of money
 Demands extensive set of forecast data and related
due diligence
 Allows explicit consideration of project risks
 Sensitive to long term growth assumptions
 Focuses on future operations
 Lacks external reference to reconcile valuation
differences
8
Section I
b)
Comparable Company Analysis
Comparable Company Analysis (‘’Comps’’)
Overview
 What is comparable company analysis?
 Provides a market-based valuation perspective on comparable publicly traded companies
 It is based on publicly available information; reflects what the many independent investors that comprise the market think

Implied valuation does not reflect premium for control or any synergy potential
 Effectiveness of this valuation method depends on the comparability of the companies selected and metrics used to compare the companies
Comparable trading analysis: Key Valuation Metrics / Multiples
Enterprise Value
Equity Value
• Revenues
• Earnings
• EBITDA
• Levered Cash Flow
• Unlevered Cash Flow
• Book Value
Multiples based on economics that all stakeholders are
entitled to (debtholders and shareholders)
Multiples based on economics that only
shareholders are entitled to
10
Comparable Company Analysis
Enterprise Value / EBITDA
Less affected and easier to interpret when there are capital
structure differences
Permits the use of statistics less affected by accounting policy
variations
General Preference for Enterprise
Value / EBITDA Multiples…
More comprehensive – focuses on the business and not just the
equity investor’s stake
More flexible – can be modified to exclude non-core assets
11
Comparable Company Analysis
Selecting Comparable Companies
•
•
•
Select the right peer group
Focus on the appropriate financial metric and ratios: each sector utilizes a standard set of ratios/metrics
Make the necessary adjustments to ensure comparability (non-recurring items, accounting policies, M&A activity)
Value Drivers
Relative
Risk Profile
Relative
Growth
Illustrative Considerations
Strategic Positioning
•
•
•
Market / Product leadership
Client-base & supply chain
Technology & patent
Size
•
•
Market presence, operating “leverage”
Good proxy for risk
Profitability
•
•
•
Cost structure
Margin analysis
Consistency
Capital Structure
•
Financial leverage
Others
•
•
•
Quality of management
Non-recurring items
Different accounting practices
Growth Profile
•
•
•
Sales, EBITDA, earnings
Consistency of growth / volatility
Growth potential
12
Comparable Company Analysis
Strengths & Limitations
Strengths
Limitations
 Objective comparison reflecting all publicly available
information on the overall sector and the individual
companies
 Challenge of finding true “comparability” within peer
groups
•
Growth / profitability expectations
•
Sector trends
•
Risk factors
 Often provides a reliable, useful first order approximation of
value
 May be forward looking, and can also be backward looking
 Ease of understanding and application
 Requires fewer assumptions (e.g. Discount rates)
 Standard practice when valuing emerging companies, as
forecasting cash flows is difficult
•
Very difficult to adjust for differences in
underlying business of comps
 Company specific issues may limit analysis and
effectiveness (e.g. limited liquidity)
 Other external factors may impact share price performance
•
Market sentiment, M&A activity in the sector and
regulatory issues
 Analysis is focused on trailing date and on next 1-2 years,
thus ignoring future performance and long-term issues
 Assumes market prices of comparable companies correctly
reflect all available information
13
Section I
c)
Precedent Transaction Analysis
Precedent Transactions Analysis
Overview
• Valuation based upon applying observed financial and operating metrics from comparable transactions
• Provides useful information on valuation multiples that acq
• Provides indication of private market value
• Value of consideration that willing buyers and sellers are prepared to exchange in current economic environment
• Many considerations discussed in Comparable Trading Analysis section apply, however three specific nuances to this
methodology must be addressed
Considerations
Relevance
•
•
•
Comparability of precedent deals and the acquired companies
Was the deal completed under comparable economic conditions
Is the other consideration comparable (cash vs. stock)?
Size
•
•
Eliminate all deals that are too small or too large compared to the potential transaction
Look at relative size of acquirer versus target
Information
•
Only include deals where sufficient / reliable information is available
Type of Deal
•
•
•
Private deals: if no public data is available, do not use in deal comparison
Timing: the more recent the data, the more relevant the benchmark
Auction / Interlopers: competition for the assets drives valuation up
15
Precedent Transactions Analysis
Strengths & Limitations
Strengths
Limitations
 Based on public information
 Relevance deteriorates over time
 Reflects different premium at which transactions have been
completed in the past (important to isolate impact of
economic cycles)
 Important not to miss context for the premium paid in
different transactions to avoid drawing misleading
conclusions.
 Overview of potential interlopers based on historical
behaviour and their strategic approach to M&A
•
Financial versus strategic investor;
•
Governance issues, commercial agreements, etc.;
 Ease of understanding and calculation
•
Asset competition driving up prices; and
 Commonly used yardstick / rule of thumb
•
Distressed sales.
 Important to distinguish what kind of assets were traded in
order to achieve like-for-like comparisons.
 Market conditions at the time of a transaction can have
substantial influence on valuation (ie. Sector consolidation)
 Challenge of true “comparability”
16
Section II
Corporate Structure Questions
Corporate Structure
Enterprise Value Questions
•
Why do you need to add minority interest to obtain enterprise value?
–
–
•
A company has 100 shares at $10, 10 options with strike price of $5 and 10 options with strike price
of $15. What are fully diluted shares?
–
–
–
•
Whenever a company owns more than 50% of another company, it is required to report the financial
performance of the whole company as part of its own performance
To compare apples with apples, you must add minority interest to get to EV so that numerator and numerator
both reflect 100% of the majority-owned subsidiary
Treasury stock method: 10 in-the-money options will be exercised  10 shares issued
With the $50 raised by the company, 5 shares are bought back
100 + 10 – 5 = 105
How to account for convertible bonds in the enterprise value formula?
–
–
If in-the-money, additional dilution to equity holders
If out-of-the-money, count the face value of the convertibles as part of debt
18
Corporate Structure
Restructuring Questions
•
A company has had positive EBITDA for the last 10 years but recently went bankrupt. How could
this happen?
–
–
–
•
What options are available to a distressed company that can’t meet debt obligations?
–
–
–
–
•
Company cannot meet its interest obligations
Large one-time event (e.g. litigation)
Too much debt is maturing at the same time and company cannot repay principal
Refinance and obtain new debt or equity
Sell the company or a division (what are the drawbacks of this approach?)
Restructure financial obligations with debt holders
File for bankruptcy and restructure the firm
What can the debt holders do to recover their principal?
–
–
–
–
Lend additional capital in form of debt or equity
Conditional financing (e.g. if the company reduces expenses, changes management, etc.)
Sale
Foreclosure
19
Corporate Structure
Restructuring Questions
•
How do you calculate cost of debt for a distressed company?
–
–
•
You can sell your company by selling equity or assets, which one would you prefer?
–
–
•
Often the public debt of a distressed company will not be very liquid, therefore it will be difficult to use bond yields as
a proxy
Look at credit spreads (CCC or D companies)
If you are the distressed seller, you prefer to sell your equity to get rid of liabilities and also because it is taxed higher
for asset sales. However, you might get higher valuations by selling individual assets
The buyer prefers to buy assets because he can pick and choose what is best
How could a decline in a company’s share price cause it to go bankrupt?
–
Customers, vendors, suppliers, and lenders would be more reluctant to do business with the distressed company
20
Section III
Valuation Questions
Valuation
Basic Valuation Methods
•
Which of the three methods yield the highest/lowest valuations?
–
–
•
How do you present valuation methodologies to a company?
–
•
Valuation methods are all “triangulated” and presented on what is called a football field analysis, alongside 52-week trading range
and research high and low valuation
Why can’t you use an Equity Value / EBITDA multiple?
–
–
•
Typically, the precedent transaction valuation method yields the highest valuation given it incorporates a control premium
The lowest valuation method is typically the Liquidation Value
Because Equity Value does not take into account debt holders, but EBITDA incorporates interest (the return on debt holders)
Multiples need to be sensitive to capital structure – if interest is included in the multiple, then so does the debt portion
Why would someone want to use EV / EBIT multiples instead of EV / EBITDA?
–
Some companies like to adjust their depreciation and amortization policies to “adjust” earnings – therefore, EV/EBIT would be a
more comparable metric amongst companies where these amounts significantly affect the multiples
Valuation
Alternative Valuation Methods
•
What is an LBO and why is used in practice? What is a good target?
–
–
•
How do you derive a liquidation value for a firm?
–
–
–
–
•
The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost
of acquisition
The purpose of leveraged buyouts is to allow companies (mostly PE firms) to make large acquisitions without having
to commit a lot of capital
Cash: 100%
A/R: 80%
Inventory: 50%
Goodwill: 0%
When would you use sum of the parts and how does it work?
–
–
Typically used for companies with different unrelated subsidiaries for which it would not be prudent to use a single
DCF or simple comps (e.g. Samsung)
Value every division separately (applying a multiple or building a DCF for each) and add up the values obtained
23
Valuation
Typical Valuation Questions
•
How do you value a Cola distributing machine?
–
–
•
We have two companies with the same financial statements and operating segments, yet company A is
trading at a higher multiple than company B. Why could this be the case?
–
–
–
–
•
Depending on the assumptions of the interviewer one might want to use any of the traditional or
unconventional valuation methods we have discussed
Not because it sounds weird that it cannot easily be valued
Growth
Management
Intangibles
Recent news
Company A and B are the same, except A leases products instead of owning them. For which of the two
would you pay a higher EV/EBITDA acquisition multiple?
–
–
Company A: lease would show up in SG&A, reducing EBITDA
Company B: depreciation charge does not show up in EBITDA, making it higher
24
Valuation
Typical Valuation Questions
•
A company will be paying down debt in the coming years. How do we account for this in a DCF?
–
•
For a mining company, would you expect higher multiples in cyclical upswings or downturns?
–
•
Trick question. You should not, we do not look at CFF when generating UFCF
During downturns because you expect commodity price to revert to mean in the future. Multiple is high
because denominator is most likely to be very low at the moment
How do you value a private company?
–
Technically you can still use a DCF but you how do you get to WACC?
•
–
Estimate WACC from public comps but add in an illiquidity and perhaps size premium to reflect the risk of the private
company
To estimate the value of a private company that is about to do an IPO, no need to add illiquidity premium as
the company will soon become public
25
Valuation
Typical Valuation Questions
•
What are some industry specific multiples?
–
–
–
–
•
How do you value a company with negative EBITDA? Pre-revenue?
–
–
•
Oil and gas: EV / Production, EV / 2P Reserves
Retail: EV / EBITDAR (R = Rent)
Technology: EV / Unique visitors
Financials: Price / Book Value
Climb-up the ladder and use EV / Revenue
Use creative multiples like EV / Clicks
What variables impact an LBO model most?
–
–
Purchase and exit multiples have the biggest impact on the returns of a model
Amount of leverage (debt) used also has a significant impact, followed by operational characteristics such as
revenue growth and EBITDA margins
26
Valuation
Accretion/Dilution Questions
•
If a company with a higher P/E acquires a company with a lower P/E, is this an accretive or dilutive
acquisition?
–
•
ONLY IF the acquisition was financed 100% with equity or cash and IF the implied P/E with the acquisition premium is
still lower can you say that the deal is accretive
Rule of thumb for Accretion/Dilution
–
–
–
If the deal involves just cash and debt, you can sum up the interest expense for debt and the foregone interest on
cash, then compare it against the seller’s Pre-Tax Income
If it’s an all-stock deal you can compare P/E multiples
But if the deal involves cash, stock, and debt, there’s no quick rule-of-thumb you can use but you can calculate it
based on the average P/E of cash (1/interest earned on cash) and average P/E of debt (D/interest %)
27
Section IV
Accounting Questions
Accounting
Classic Machine Question
•
On January 1st, company A buys a new machine for $100, financed with $50 in cash and $50 in debt. It will
be depreciated on a straight line basis for 10 years. It will also contribute to revenue in the coming fiscal
year by an additional $10 and COGS of $5. How will this affect all three financial statements at year end on
December 31st? Assume a tax rate of 50% and interest rate of 10%.
I/S
Revenue
COGS
Depreciation
EBIT
Interest
EBT
Tax
Net Income
$ 10.00
$ (5.00)
$ (10.00)
$ (5.00)
$ (5.00)
$ (10.00)
$ 5.00
$ (5.00)
C/S
Net Income $ (5.00)
Depreciation $ 10.00
CFO
$
5.00
Debt
CFF
$ 50.00
$ 50.00
Machine
CFI
$ (100.00)
$ (100.00)
B/S
Cash
PPE
Depreciation
Assets
$ (45.00)
$ 100.00
$ (10.00)
$ 45.00
Debt
R.E.
L + S.E.
$ 50.00
$ (5.00)
$ 45.00
Accounting Questions
Typical Accounting Questions
•
How is GAAP/IFRS accounting different from tax accounting?
–
GAAP is accrual based but tax is cash based
•
–
•
Tax is only concerned with revenue/expenses in the current period and what income you owe
GAAP uses straight-line depreciation whereas tax uses accelerated depreciation
What are examples of non-recurring charges we need to add back to a company’s EBIT or EBITDA when
looking at financial statements?
–
–
–
–
–
–
–
Restructuring charges
Goodwill impairment
Asset write-downs
Bad debt expense
Legal expenses
Disaster expenses
Changes in accounting procedures
30
Accounting Questions
Typical Accounting Questions
•
What are NOL’s and how are they valued?
–
–
–
•
Net operating losses: tax credit created when a company records losses. Can be carried back 3 years (2 in USA) and
forward 20 years
You should always carry back as much as possible today and exercise the credits as soon as possible in the future
Value = NOLs that can be carried back today*Tax rate + PV(NOLs to be used in future)*Tax rate
What is a depreciation waterfall?
Depreciation Waterfall
2013 A
Capital Expenditures
Useful Life
$100.00 $100.00 $100.00 $100.00 $100.00 $100.00
5 years 5 years 5 years 5 years 5 years 5 years
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
$20.00
Depreciation
$20.00
2014 E
2015 E
2016 E
2017 E
$20.00
$20.00
$20.00
$20.00
$20.00
2018 E
$20.00
$20.00
$20.00
$20.00
$20.00
$20.00
$20.00
$20.00
$20.00
$40.00
$60.00
$80.00 $100.00 $100.00
$20.00
$20.00
$20.00
$20.00
$20.00
31
Accounting Questions
Typical Accounting Questions
•
Why would the D&A numbers from the I/S differ from the ones on the C/S? Which one should you use?
–
•
When does goodwill impairment happen?
–
•
This happens if D&A is embedded in other I/S line items. When this happens, you need to use the C/S
number to arrive at EBITDA because you would be undercounting D&A
When you reassess the value of the company you acquired (annual impairment test) and you find out it is
worth significantly less. An example of this is tech companies that have been acquired before the tech
bubble
A company switches from LIFO to FIFO in an inflationary environment; how does it affect its statements?
–
Operating income and earnings will be overstated (lower COGS). Inventory will be higher as “cheaper” items
will be sold first. CFO will be higher due to increased earnings, offset by a change in NWC
32
Section V
Pitch a Stock
Pitch a Stock
Capital One Financial
Best in class
financial metrics
Shift from
growth to
returning capital
to shareholders
Strong macro
support
Discounted valuation
The market is discounting COF to its peers even though it has best in industry financial metrics, strong growth
prospects in the consumer credit cards, and a shift in focus toward returning value to shareholders
34
Q&A
Contact
•
Xavier Le Sieur – Bank of America, Merrill Lynch (Investment Banking)
 xavier.lesieur@mail.mcgill.ca

I would be happy to help with:




Cover Letter & Resume Review
Mock Interviews
General Finance Jobs available
Reviewing Offers
36