Valuation Questions & Answers – Basic Questions and Answers

Valuation Questions & Answers – Basic Questions and Answers What are the 3 major valuation methodologies? Comparable Companies, Precedent Transactions and Discounted Cash Flow Analysis. 2. Rank the 3 valuation methodologies from highest to lowest expected value Trick question - there is no ranking that always holds. In general, Precedent Transactions will be higher than Comparable Companies due to the Control Premium built into acquisitions. 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. DCF might be lower than Comparables if there's liquidity premium When would you not use a DCF in a Valuation? You do not use a DCF if the company has unstable or unpredictable cash flows (tech or bio-tech startup) or when debt and working capital serve a fundamentally different role. For example, banks and financial institutions do not re-invest debt and working capital is a huge part of their Balance Sheets - so you wouldn't use a DCF for such companies. What other Valuation methodologies are there? • Liquidation Valuation - Valuing a company's assets, assuming they are sold off and then subtracting liabilities to determine how much capital, if any, equity investors receive • Replacement Value - Valuing a company based on the cost of replacing its assets • LBO Analysis - Determining how much a PE firm could pay for a company to hit a "target" IRR, usually in the 20-25% range • Sum of the Parts - Valuing each division of a company separately and adding them together at the end • M&A Premiums Analysis - Analyzing M&A deals and figuring out the premium that each buyer paid, and using this to establish what your company is worth • Future Share Price Analysis - Projecting a company's share price based on the P / E multiples of the public company comparables, then discounting it back to its present value When would you use a Liquidation Valuation? This is most common in bankruptcy scenarios and is used to see whether equity shareholders will receive any capital after the company's debts have been paid off. It is often used to advise struggling businesses on whether it's better to sell off assets separately or to try and sell the entire company. When would you use Sum of the Parts? This is most often used when a company has completely different, unrelated divisions - a conglomerate like General Electric, for example. If you have a plastics division, a TV and entertainment division, an energy division, a consumer financing division and a technology division, you should not use the same set of Comparable Companies and Precedent Transactions for the entire company. Instead, you should use different sets for each division, value each one separately, and then add them together to get the Combined Value. When do you use an LBO Analysis as part of your Valuation? Obviously you use this whenever you're looking at a Leveraged Buyout - but it is also used to establish how much a private equity firm could pay, which is usually lower than what companies will pay. It is often used to set a "floor" on a possible Valuation for the company you're looking at. What are the most common multiples used in Valuation? The most common multiples are EV/Revenue, EV/EBITDA, EV/EBIT, P/E (Share Price / Earnings per Share), and P/BV (Share Price / Book Value). What are some examples of industry-specific multiples? Technology (Internet): EV / Unique Visitors, EV / Pageviews Retail / Airlines: EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rent) Energy: P / MCFE, P / MCFE / D (MCFE = 1 Million Cubic Foot Equivalent, MCFE/D = MCFE per Day), P / NAV (Share Price / Net Asset Value) Real Estate Investment Trusts (REITs): Price / FFO, Price / AFFO (Funds From Operations, Adjusted Funds From Operations) Technology and Energy should be straightforward - you're looking at traffic and energy reserves as value drivers rather than revenue or profit. For Retail / Airlines, you often remove Rent because it is a major expense and one that varies significantly between different types of companies. For REITs, Funds From Operations is a common metric that adds back Depreciation and subtracts gains on the sale of property. Depreciation is a non-cash yet extremely large expense in real estate, and gains on sales of properties are assumed to be non-rec When you're looking at an industry-specific multiple like EV / Scientists or EV / Subscribers, why do you use Enterprise Value rather than Equity Value? You use Enterprise Value because those scientists or subscribers are "available" to all the investors (both debt and equity) in a company. The same logic doesn't apply to everything, though - you need to think through the multiple and see which investors the particular metric is "available" to. Would an LBO or DCF give a higher valuation? Technically it could go either way, but in most cases the LBO will give you a lower valuation. Here's the easiest way to think about it: with an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year - you're only valuing it based on its terminal value. With a DCF, by contrast, you're taking into account both the company's cash flows in between and its terminal value, so values tend to be higher. Note: Unlike a DCF, an LBO model by itself does not give a specific valuation. Instead, you set a desired IRR and determine how much you could pay for the company (the valuation) based on that. How would you present these Valuation methodologies to a company or its investors? Usually you use a "football field" chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number. 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 value of the apple tree's cash flows (intrinsic valuation). Yes, you could do a DCF for anything - even an apple tree. Why can't you use Equity Value / EBITDA as a multiple rather than Enterprise Value / EBITDA? EBITDA is available to all investors in the company - rather than just equity holders. Similarly, Enterprise Value is also available to all shareholders so it makes sense to pair them together. Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect the company's entire capital structure - only the part available to equity investors. When would a Liquidation Valuation produce the highest value? This is highly unusual, but it could happen if a company had substantial hard assets but the market was severely undervaluing it for a specific reason (such as an earnings miss or cyclicality). As a result, the company's Comparable Companies and Precedent Transactions would likely produce lower values as well - and if its assets were valued highly enough, Liquidation Valuation might give a higher value than other methodologies. Let's go back to 2004 and look at Facebook back when it had no profit and no revenue. How would you value it? You would use Comparable Companies and Precedent Transactions and look at more "creative" multiples such as EV/Unique Visitors and EV/Pageviews rather than EV/Revenue or EV/EBITDA. You would not use a "far in the future DCF" because you can't reasonably predict cash flows for a company that is not even making money yet. This is a very common wrong answer given by interviewees. When you can't predict cash flow, use other metrics - don't try to predict cash flow anyway! What would you use in conjunction with Free Cash Flow multiples - Equity Value or Enterprise Value? Trick question. For Unlevered Free Cash Flow, you would use Enterprise Value, but for Levered Free Cash Flow you would use Equity Value. Remember, Unlevered Free Cash Flow excludes Interest and thus represents money available to all investors, whereas Levered already includes Interest and the money is therefore only available to equity investors. Debt investors have already "been paid" with the interest payments they received. You never use Equity Value / EBITDA, but are there any cases where you might use Equity Value / Revenue? Never say never. It's very rare to see this, but sometimes large financial institutions with big cash balances have negative Enterprise Values - so you might use Equity Value / Revenue instead. You might see Equity Value / Revenue if you've listed a set of financial and nonfinancial companies on a slide, you're showing Revenue multiples for the non-financial companies, and you want to show something similar for the financials. Note, however, that in most cases you would be using other multiples such as P/E and P/BV with banks anyway. How do you select Comparable Companies / Precedent Transactions? The 3 main ways to select companies and transactions: 1. Industry classification 2. Financial criteria (Revenue, EBITDA, etc.) 3. Geography For Precedent Transactions, you often limit the set based on date and only look at transactions within the past 1-2 years. The most important factor is industry - that is always used to screen for companies/transactions, and the rest may or may not be used depending on how specific you want to be. Here are a few examples: Comparable Company Screen: Oil & gas producers with market caps over $5 billion Comparable Company Screen: Digital media companies with over $100 million in revenue Precedent Transaction Screen: Airline M&A transactions over the past 2 years involving sellers with over $1 billion in revenue Precedent Transaction Screen: Retail M&A transactions over the past year How do you apply the 3 valuation methodologies to actually get a value for the company you're looking at? Sometimes this simple fact gets lost in discussion of Valuation methodologies. You take the median multiple of a set of companies or transactions, and then multiply it by the relevant metric from the company you're valuing. Example: If the median EBITDA multiple from your set of Precedent Transactions is 8x and your company's EBITDA is $500 million, the implied Enterprise Value would be $4 billion. To get the "football field" valuation graph you often see, you look at the minimum, maximum, 25th percentile and 75th percentile in each set as well and create a range of values based on each methodology. What do you actually use a valuation for? Usually you use it in pitch books and in client presentations when you're providing updates and telling them what they should expect for their own valuation. It's also used right before a deal closes in a Fairness Opinion, a document a bank creates that "proves" the value their client is paying or receiving is "fair" from a financial point of view. Valuations can also be used in defense analyses, merger models, LBO models, DCFs (because terminal multiples are based off of comps), and pretty much anything else in finance. Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium? This could happen for a number of reasons: • The company has just reported earnings well-above expectations and its stock price has risen recently. • It has some type of competitive advantage not reflected in its financials, such as a key patent or other intellectual property • It has just won a favorable ruling in a major lawsuit. • It is the market lea What are the flaws with public company comparables? • 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. How do you take into account a company's competitive advantage in a valuation? 1. Look at the 75th percentile or higher for the multiples rather than the Medians. 2. Add in a premium to some of the multiples. 3. Use more aggressive projections for the company. In practice you rarely do all of the above - these are just possibilities. Do you ALWAYS use the median multiple of a set of public company comparables or precedent transactions? There's no "rule" that you have to do this, but in most cases you do because you want to use values from the middle range of the set. But if the company you're valuing is distressed, is not performing well, or is at a competitive disadvantage, you might use the 25th percentile or something in the lower range instead - and vice versa if it's doing well. You mentioned that Precedent Transactions usually produce a higher value than Comparable Companies - can you think of a situation where this is not the case? Sometimes this happens when there is a substantial mismatch between the M&A market and the public market. For example, no public companies have been acquired recently but there have been a lot of small private companies acquired at extremely low valuations. For the most part this generalization is true but keep in mind that there are exceptions to almost every "rule" in finance. What are some flaws with precedent transactions? • Past transactions are rarely 100% comparable - the transaction structure, size of the company, and market sentiment all have huge effects. • Data on precedent transactions is generally more difficult to find than it is for public company comparables, especially for acquisitions of small private companies. Two companies have the exact same financial profile and are bought by the same acquirer, but the EBITDA multiple for one transaction is twice the multiple of the other transaction - how could this happen? Possible reasons: 1. One process was more competitive and had a lot more companies bidding on the target. 2. One company had recent bad news or a depressed stock price so it was acquired at a discount. 3. They were in industries with different median multiples. Why does Warren Buffett prefer EBIT multiples to EBITDA multiples? Warren Buffett once famously said, "Does management think the tooth fairy pays for capital expenditures?" He dislikes EBITDA because it excludes the often sizable Capital Expenditures companies make and hides how much cash they are actually using to finance their operations. In some industries there is also a large gap between EBIT and EBITDA - anything that is very capital-intensive, for example, will show a big disparity. The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company's profitability. What's the difference between them, and when do you use each one? P / E depends on the company's capital structure whereas EV / EBIT and EV / EBITDA are capital structure-neutral. Therefore, you use P / E for banks, financial institutions, and other companies where interest payments / expenses are critical. EV / EBIT includes Depreciation & Amortization whereas EV / EBITDA excludes it - you're more likely to use EV / EBIT in industries where D&A is large and where capital expenditures and fixed assets are important (e.g. manufacturing), and EV / EBITDA in industries where fixed assets are less important and where D&A is comparatively smaller (e.g. Internet companies). If you were buying a vending machine business, would you pay a higher multiple for a business where you owned the machines and they depreciated normally, or one in which you leased the machines? The cost of depreciation and lease are the same dollar amounts and everything else is held constant. You would pay more for the one where you lease the machines. Enterprise Value would be the same for both companies, but with the depreciated situation the charge is not reflected in EBITDA - so EBITDA is higher, and the EV / EBITDA multiple is lower as a result. For the leased situation, the lease would show up in SG&A so it would be reflected in EBITDA, making EBITDA lower and the EV / EBITDA multiple higher. 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 as "liquid" as the public comps. • 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. • A DCF gets tricky because a private company doesn't have a market capitalization or Beta - you would probably just estimate WACC based on the public comps' WACC rather than trying to calculate it. 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 / WACC calculation in a DCF because they are not public and therefore have no values for market cap or Beta. What is the purpose of using multiples in valuation? Since absolute values cannot be compared, multiples are used to standardize a company's value on a per-unit basis. This enables comparisons in value amongst similar companies, which is the premise of relative valuation. For any valuation multiple to be meaningful, a contextual understanding of the target company, such as its fundamental drivers and general industry knowledge, is required. Should the target company being valued be included in its peer group? Many professionals exclude the target company being valued from the peer group because the target's inclusion would skew the multiple towards the target's current valuation. However, if the intuition behind a comps analysis is that the market may misprice individual stocks but is correct on the whole, then logic dictates that the target should be included in its market-based valuation. In M&A, why is a control premium paid? A control premium refers to the amount an acquirer paid over the market trading value of the shares being acquired (usually shown as a percentage). As a practical matter, a control premium is necessary to incentivize existing shareholders to sell their shares. It's improbable that an acquirer could get a controlling interest in a target company without first offering a reasonable purpose premium over the current price. Besides incentivizing existing shareholders to sell, what other factors lead to higher control premiums being paid? - Competitive Deals - Synergies - Asset Scarcity Many acquirers (strategics in the majority of cases) might pay a higher premium if the specific asset is a centerpiece to their future plans and there are no other acquisition targets in the market that meet their criteria. - Undervalued Target: The target company might be perceived to be significantly undervalued from the buyer's viewpoint. From their perspective, the purchase price could be a moderate premium when compared to their own fair value assessment of the target, whereas to others the buyer paid an unreasonably high premium. - Mismanagement: A mismanaged company coincides with the previous point, as this typically leads to underperformance. The acquirer will most likely be under the impression that the management should be replaced, and through operational improvements, a significant amount of value that is currently not being fully taken advantage of could be derived. Thus, a target acquired for this reason will be immediately restructured, beginning with the management team being replaced post-closing. When valuing a company using multiples, what are the trade-offs of using LTM vs. forward multiples? Using historical (LTM) profits have the advantage of being actual results. This is important because EBITDA, EBIT, and EPS forecasts are subjective and especially problematic for smaller public firms, whose guidance is less reliable and harder to obtain. That said, LTM suffers from the problem that historical results are often distorted by non-recurring expenses and income, misrepresenting the company's recurring operating performance. When using LTM results, non-recurring items must be excluded to get a "clean" multiple. In addition, companies are often acquired based on their future potential, making forward multiples more relevant. Therefore, both LTM and forward multiples are often presented side-by-side, rather than picking one. Should two identical companies with different leverage ratios trade at different EV/EBITDA multiples? You would expect the EV/EBITDA multiples to be similar because enterprise value and EBITDA measure a company's value and profits independent of its capital structure. Technically, they won't be exactly equal because enterprise value depends on the cost of capital, so there'll be some variation. Should two identical companies with different leverage ratios trade at different P/E multiples? What happens to the ratio if leverage increases? P/E multiples can vary significantly due to leverage differences for otherwise identical companies. All else being equal, as a company borrows debt, the EPS (denominator) will decline due to higher interest expense. The impact on the share price, on the other hand, is hard to predict and depends on how the debt is used: - If the debt proceeds go unused and generate no return, the share price will decline to reflect the incremental cost of debt with no commensurate growth or investment. In this scenario, the share price and P/E ratio can be expected to decline. - But if that debt were used to invest and grow the business, the P/E ratio should increase. Simply put, debt adds more risk to equity investors (given their junior position in the capital structure) with little potential return, and investors will value the company at a lower P/E. What does a high P/E ratio relative to a peer group imply? If a company has a high P/E ratio in relation to its peer group, this might mean the market is overvaluing the company. Alternatively, it could mean the company has less earnings than its peer group (or is a younger company). For this reason, the use of P/E multiples is most useful when the company is mature and its peer group has a similar capital structure. A high P/E ratio is almost always a positive sign that the market expects the company's earnings to grow in the future and is optimistic about its growth prospects, as well as its current capex (which is causing the lower earnings) will pay off over time and eventually lead to greater profits. A company has an EPS of $2.00 that has declined to $1.00 four years later. Assume its share price has remained the same at $10. Is its current P/E ratio higher or lower than its four year-back P/E ratio, and how would you interpret this situation? The company's P/E ratio would be higher. The company's four year-back P/E ratio was 5.0x and its current P/E ratio is 10.0x. Therefore, its P/E doubled after its EPS declined by $1.00. One potential interpretation is that the company is now overvalued and shouldn't be trading at a 10.0x multiple given the deteriorated EPS. Realistically, the market would view a decrease in EPS negatively, resulting in a lower share price and valuation. But since the share price didn't change, there are a few possible explanations: 1. The company could have issued more shares to raise capital that had a dilutive impact on EPS. 2. The company might have made a dilutive acquisition with stock as the main purchase consideration. In both cases, the cause of the lower EPS is the increase in the denominator. The share price remaining constant suggests the market reaction to how the company plans to use the newly raised capital or the M&A deal was positive, otherwise, the share price would've dropped. Similar to how EPS can be artificially boosted from share buybacks, it can decrease without there being an actual drop in performance. The issuance of additional shares typically results in the per-share value decreasing from the dilution, but the $10 share price is the post-dilution share price (meaning, the price was upheld despite the dilution). When would the use of the PEG ratio be appropriate The PEG ratio is used to standardize the P/E ratio and enable comparisons among companies with different expected long-term growth rates (g). As a broad rule of thumb, a stock is fairly valued when the PEG ratio is 1, undervalued when the PEG ratio is below 1, and overvalued when above 1. PEG Ratio = (P/E)/g There are two approaches for the growth rate used: 1. Trailing PEG: In the first option, the growth rate can be based on a company's historical growth. For example, the LTM growth rate could be used, or the annualized growth rate over the past 3-5 years. 2. Forward PEG: The other, more commonly used option calculates the growth rate from a 1-3 year projection based on consensus estimates or an annualized version of those growth rates. When would you value a business using the P/B ratio? The P/B ratio can be used when the company's book value captures a substantial part of its real value. An example would be commercial banks, as most of their assets and liabilities are frequently re-valued and similar to their actual market values.