Valuation Questions & Answers – Advanced Questions and Answers

Valuation Questions & Answers – Advanced Questions and Answers Things to Keep in Mind These questions cover 3 different topics: 1. More advanced valuation methodologies. 2. Valuation nuances such as calendarization, non- recurring charges, and where to find information on deals and companies. 3. Industry-specific valuation and special cases, such as private companies, IPOs, and more. There are not that many truly "Advanced" interview questions on Valuation because most of the difficulty lies in the mechanics and searching through companies' filings to find and adjust information. And questions on those points are difficult and time-consuming to test in the time-constrained setting of an interview; even if you get a case study, they're more likely to ask you to construct a basic valuation model based on information they give you. Walk me through an M&A premiums analysis. The purpose of this analysis is to look at similar transactions and calculate the premiums that buyers have paid over public sellers' share prices when acquiring them. For example, if a company is trading at $10.00/share and the buyer acquires it for $15.00/share, that's a 50% premium. 1. First, select the precedent transactions based on industry, date (the past 2-3 years, for example), and size (ex: over $1 billion market cap). 2. For each transaction, get the seller's share price 1 day, 20 days, and 60 days before the transaction was announced (you can also look at 90-day intervals, or 30 days, 45 days, etc.). 3. Then, calculate the 1-day premium, 20-day premium, etc. by dividing the per-share purchase price by the appropriate share price on each day. 4. Get the medians for each set, and then apply them to your company's current share price, share price 20 days ago, and so on to estimate how much of a premium a buyer might pay for it. You only use this analysis when valuing a public company because private companies don't have share prices. Sometimes the set of companies here is exactly the same as your set of precedent transactions, but typically it is broader. Both M&A premiums and precedent transactions involve analyzing previous M&A transactions. What's the difference in how we select them? • All the sellers in the M&A premiums analysis must be public. • Usually we use a broader set of transactions for M&A premiums - we might use fewer than 10 precedent transactions but we might have dozens of M&A premiums. The industry and financial screens are usually less stringent. • Aside from those, the screening criteria are similar - financial metrics, industry, geography, and date. Walk me through a future share price analysis. The purpose of this analysis is to project what a company's share price might be 1 or 2 years from now and then discount it back to its present value. 1. Get the median historical (usually Trailing Twelve Months, or TTM) P / E multiple of the public company comparables. 2. Apply this P / E multiple to your company's 1-year forward or 2-year forward projected EPS to get its implied future share price. 3. Then, discount this share price back to its present value by using a discount rate in-line with the company's Cost of Equity. You normally look at a range of P / E multiples as well as a range of discount rates for this type of analysis, and then create sensitivity tables with these as inputs. Technically, you could also use other multiples but P / E is the most common one here. Walk me through a Sum-of-the-Parts analysis. In a Sum-of-the-Parts analysis, you value each division of a company using separate comparables and transactions, get to separate multiples, and then add up each division's value to get the total for the company (example from our modeling courses shown below): Once again, picking a range of multiples and values is crucial and you would never just say, "The exact multiple to use for Search Advertising is 6.5x!" How do you value Net Operating Losses (NOLs) and take them into account in a valuation? You determine how much the NOLs will save the company in taxes in future years, and then calculate the net present value of the total future tax savings. There are two ways to estimate the tax savings in future years: 1. Assume that a company can use its NOLs to completely offset its taxable income until the NOLs run out. 2. In an acquisition scenario, use Section 382 and multiply the highest adjusted long-term rate ( You might look at NOLs in a valuation but you rarely factor them in - if you did, they would be treated similarly to Cash and you would subtract NOLs to go from Equity Value to Enterprise Value, and vice versa (see the Equity Value and Enterprise Value section of the guide). What's the purpose of "calendarization"? How do you use it in a valuation? You "calendarize" because different companies have different fiscal years. For example, some companies' fiscal years may run from January 1 to December 31 - but others may have fiscals year that run from April 1 to March 31, or from July 1 to June 30. This creates a problem because you can't directly compare all these periods - you always need to look at the same calendar period when you create a set of Public Comps. So you adjust all the fiscal years by adding and subtracting "partial" periods. You almost always adjust other companies' fiscal years to match the company you're valuing. Let's say that you need to adjust a July 1 - June 30 fiscal year to make it end on December 31 instead. In this scenario, you'd take the July 1 - June 30 period, add the financials from the June 30 - December 31 period this year, and then subtract the financials from the June 30 - December 31 period the previous year. Here's a set of diagrams to illustrate the process: [Image] Does calendarization apply to both Public Comps and Precedent Transactions? It applies mostly to Public Comps because there's a high chance that fiscal years will end on different dates with a big enough set of companies. However, in effect you do calendarize for Precedent Transactions as well because you normally look at the Trailing Twelve Months (TTM) period for each deal. So if an acquisition was announced on April 30 and the company's fiscal year ends on December 31, you will calendarize the revenue, EBITDA, and so on by adding the January 1 - March 31 period of the current year and subtracting the January 1 - March 31 period of the previous year. I'm looking at financial data for a public company comparable, and it's April (Q2) right now. Walk me through how you would "calendarize" this company's financial statements to show the Trailing Twelve Months as opposed to just the last Fiscal Year. The formula to calendarize financial statements is as follows: TTM = Most Recent Fiscal Year + New Partial Period - Old Partial Period So in the example above, we would take the company's Q1 (January 1 - March 31 of this year ) numbers, add the most recent fiscal year's (January 1 - December 31 of last year) numbers, and then subtract the previous year's Q1 numbers (January 1 - March 31 of last year). For US-based companies you can find these quarterly numbers in the 10-Q; for international companies they're in the interim reports. Let's say that you're looking at a set of Public Comps with fiscal years ending on March 31, June 30, and December 31. The company you're analyzing has a fiscal year that ends on June 30. How would you calendarize the financials for these companies? You generally calendarize based on the fiscal year of the company you're valuing. So in this case you would adjust and make the other companies' fiscal years end on June 30. For the one with the March 31 year, you would take that year and then add the March 31 - June 30 period, and subtract the March 31 - June 30 period from the previous year. For the one with the December 31 year, you would take that year and add the January 1 - June 30 period, and subtract the January 1 - June 30 period from the previous year. You're analyzing the financial statements of a Public Comp, and you see Income Statement line items for Restructuring Expenses and an Asset Disposal. Should you add these back when calculating EBITDA? This is a trick question on multiple levels: 1. First, you should always take these charges from the Cash Flow Statement if possible - sometimes the charges are partially embedded within other line items on the Income Statement. If they don't appear on the Cash Flow Statement, look up them in the Notes to the Financial Statements. 2. Second, you only add them back if they're truly non-recurring charges. If a company claims it has been "restructuring" for the past 5 years, well, that's not exactly a non-recurring expense. There's a lot of subtlety when adjusting for these types of charges and there is not necessarily a "correct" way to do it in all cases. How do non-recurring charges typically affect valuation multiples? Most of the time, these charges effectively increase valuation multiples because they reduce metrics such as EBIT, EBITDA, and EPS. You could have non-recurring income as well (e.g. a one-time asset sale) which would have the opposite effect. So be aware that it works both ways, and be ready to adjust for both non-recurring expenses and non-recurring income sources. We're valuing a company's 30% interest in another company - in other words, an Investment in Equity Interest or Associate Company. We could just multiply 30% by that company's value, but what other adjustments might we make? Normally, you'll apply some type of "Liquidity Discount" or "Lack of Control Discount" and assume that the stake is worth 20-30% (or more) less than the book value because the company you're valuing doesn't truly control this other company. Additionally, you may value these types of investments by assuming that they get sold off - so you would apply the company's tax rate as well and calculate the after-tax proceeds, after any discounts have been applied. I have a set of public company comparables and need to get the projections from equity research. How do I select which report to use? This varies by bank and group, but here are two common methods: 1. You pick the report with the most detailed information. 2. You pick the report with numbers in the middle of the range. Note that you do not pick reports based on which bank they're coming from. So if you're at Goldman Sachs, you would not pick all Goldman Sachs equity research - that would actually be bad because then the valuation would be less objective. I have a set of precedent transactions but I'm missing information like EBITDA for a lot of the companies, since they were private. How can I find it if it's not available via public sources? 1. Search online and see if you can find press releases or articles in the financial press with these numbers. 2. Failing that, look in equity research for the buyer around the time of the transaction and see if any of the analysts estimate the seller's numbers. 3. Also look at online sources like Capital IQ and Factset and see if any of them disclose numbers or give estimates for the deals. 10. You're analyzing a set of transactions where the buyers have acquired everything from 20% to 80% to 100% of other companies. Should you use all of them as part of your valuation? Ideally, no. It is best to limit the set to just 100% acquisitions, or at least 50% acquisitions, because the dynamics are very different when you acquire an entire company or a majority of a company compared to when you acquire only a 20% or 30% stake. You may not always be able to do this due to lack of data or lack of transactions, but generally transactions get less and less comparable as the percentage acquired varies by more and more. You're analyzing a transaction where the buyer acquired 80% of the seller for $500 million. The seller's revenue was $300 million and its EBITDA was $100 million. It also had $50 million in cash and $100 million in debt. What were the revenue and EBITDA multiples for this deal? First, calculate the Equity Value: $500 million / 80% = $625 million. That represents the value of 100% of the seller. Then, calculate Enterprise Value: $625 million - $50 million + $100 million = $675 million. The revenue multiple is $675 million / $300 million, or 2.3x, and the EBITDA multiple is $675 million / $100 million, or 6.8x. How far back and forward do we usually go for public company comparable and precedent transaction multiples? Usually you look at the TTM (Trailing Twelve Months) period for both sets, and then you look forward either 1 or 2 years. You're more likely to look backward more than 1 year and go forward more than 2 years for public company comparables; for precedent transactions it's odd to go forward more than 1 year because the information is more limited. I have one company with a 40% EBITDA margin trading at 8x EBITDA, and another company with a 10% EBITDA margin trading at 16x EBITDA. What's the problem with comparing these two valuations directly? There's no "rule" that says this is not allowed, but it can be misleading to compare companies with dramatically different margins. Due to basic arithmetic, the 40% margin company will usually have a lower multiple - whether or not its actual value is lower. See the diagram below: [Image] In this situation, we might consider screening based on margins and remove the outliers - you would not try to "normalize" the EBITDA multiples based on margins. How do you value a private company? 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 "liquid" like the public comps are. • 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. You can still calculate Equity Value, but a "per-share price" is meaningless for a private company. • A DCF gets tricky because a private company doesn't have a market capitalization or Beta - you would probably estimate WACC based on the public comps' WACC rather than trying to calculate it yourself. Let's say we're valuing a private company. Why might we discount the public company comparable multiples but not the precedent transaction multiples? 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. Can you use private companies as part of your valuation? 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 or WACC calculation in a DCF because they are not public and therefore have no values for market cap or Beta. Walk me through an IPO valuation for a company that's about to go public. 1. Unlike normal valuations, in an IPO valuation we only care about public company comparables - we select them as we normally would. 2. After picking the public company comparables, we decide on the most relevant multiple(s) to use and then estimate our company's Enterprise Value based on that (or Equity Value depending on the multiple). 3. Once we have the Enterprise Value, we work backwards to calculate Equity Value. We also have to account for the IPO proceeds in here, i.e. by adding them since we're working backwards (these proceeds are what the company receives in cash from the IPO). 4. Then we divide by the total number of shares (old and newly created) to get its per-share price. When people say "An IPO priced at..." this is what they're referring to. If you were using P / E or any other "Equity Value-based multiple" in step #2 here, then you could skip step #3 and just take into account the cash proceeds. 5. How do you value banks and financial institutions differently from other companies? For relative valuation, the methodologies (public comps and precedent transactions) are the same but the metrics and multiples are different: • The financial criteria consist of Assets, Loans, or Deposits rather than revenue or EBITDA. • You look at metrics like ROE (Return on Equity = Net Income / Shareholders' Equity), ROA (Return on Assets = Net Income / Total Assets), and Book Value and Tangible Book Value rather than Revenue, EBITDA, and so on. • You use multiples such as P / E, P / BV, and P / TBV rather than EV / EBITDA. Rather than a traditional DCF, you use 2 different methodologies for intrinsic valuation: • In a Dividend Discount Model (DDM) you sum up the present value of a bank's dividends in future years and then add it to the present value of the bank's terminal value, usually basing that on a P / BV or P / TBV multiple. • In a Residual Income Model (also known as an Excess Returns Model), you take the bank's current Book Value and simply add the present value of the excess returns to that Book Value to value it. The "excess return" each year is (ROE Book Value) - (Cost of Equity Book Value) - basically by how much the returns exceed your expectations. You need to use these methodologies and multiples because Interest is a critical component of a bank's revenue and because Debt is a "raw material" rather than just a financing source; also, banks' Book Values are usually very close to their Market Caps. See the industry-specific guides for more detail here. Walk me through how we might value an oil & gas company and how it's different from a "standard" company. Public comps and precedent transactions are similar, but: • You might screen based on metrics like Proved Reserves or Daily Production. • You would look at the above metrics as well as R/P (Proved Reserves / Last Year's Production), EBITDAX, and other industry-specific ones, and use matching multiples. You could use a standard Unlevered DCF to value an oil & gas company as well, but it's more common to see a NAV (Net Asset Value) Model where you take the company's Proved Reserves, assume they produce revenue until depletion, assign a cost to the production in each year, and take the present value of those cash flows to value the company. There are also a host of other complications: oil & gas companies are cyclical and have no control over the prices they receive, companies use either "full-cost accounting" or "successful efforts accounting" and treat the exploration expense differently according to that, and so on. See the industry-specific guides for more detail here. Walk me through how you would value a REIT (Real Estate Investment Trust) and how it differs from a "normal" company. Similar to energy, real estate is asset-intensive and a company's value depends on how much cash flow specific properties generate. • You look at Price / FFO per Share (Funds from Operations) and Price / AFFO per Share (Adjusted Funds from Operations), which add back Depreciation and subtract Gains (and add Losses) on property sales. • A Net Asset Value (NAV) model is the most common intrinsic valuation methodology; you assign a Cap Rate to the company's projected NOI and multiply to get the value of its real estate, adjust and add its other assets, subtract liabilities and divide by its share count to get NAV per Share, and then compare that to its current share price. • You value properties by dividing Net Operating Income (NOI) (Property's Gross Income - Property-Level Operating Expenses and Property Taxes) by the capitalization rate (based on market data). • Replacement Valuation is more common because you can actually estimate the cost of buying new land and building new properties. • A DCF is still a DCF, but it flows from specific properties instead and it tends to be far less common than the NAV model. See the industry-specific guides for more detail here.