Valuation Questions plus Answers

Valuation Questions plus Answers What are the two ways to value a company? Intrinsic and Relative (two within each Transaction Comparables, Trading Comparables, DCF , LBO) What are the two types of intrinsic valuation Discounted Cash Flow (more respected in academia and more commonly used in IB) and Leveraged Buyout What are the two types of relative valuation 1. Compare similar transactions 2. compare similar companies walk me through transaction comps higher multiples 1. Determine universe of comparable transactions 2. Calculate multiples on LTM basis 3.Apply the calculated mean/median to target's corresponding operating metrics to arrive at a value walk me through Trading comp 1. select comparable companies 2. Determine enterprise value of each 3. Decide on a multiple that would provide the best model (EV/Sales, EV/EBITDA, P/E) 4. Find the multiple for all of the comparable companies 5. Take median/avg multiple 6. multiply by EBITDA to find enterprise value Problems with relative Problem: company might not be similar structure, and a variety of factors may explain why a similar company had a specific value at any point in time Ex: pharmaceutical w/ expiring patent, before or after 2008, etc. High level: explain intrinsic The value of a business equals the sum of all the cash flows it will generate, discounted to the present value using a discount rate that reflects the riskiness of the business. High level: explain LBO (leveraged buyout) analyses -Value to a financial sponsor -Value based on debt repayment or return on investment -provides a "floor" valuation for the company, and is useful in determining what a financial sponsor can afford to pay for the target and still realize an adequate return on its investment. High level: explain what an LBO deal is -buyer invests a small amount of equity and uses leverage (debt or other non-equity sources of financing) to acquire a company Other than for a leveraged buyout, when do you use an LBO Analysis as part of your Valuation? -set a "floor" on a possible Valuation for the company you're looking at -used to establish how much a private equity firm could pay, which is usually lower than what companies will pay. Pros to LBO analysis -good for finding LBO opportunities -highlights effects of adding leverage to business -shows what value any financial bidder will have to exceed -estimates potential equity returns to the business, provides sensitivity of returns Cons to LBO -Value obtained is sensitive to projections and how aggressive assumptions were -underestimate the sale value b/c it ignores synergies -Sponsors/financial buyers pay smaller premium than strategic b/c they're in it for a shorter period Walk me through an LBO - Make purchase price assumptions on purchase price, debt repayment, and -Create sources to determine how the transaction will be financed and the capital uses -Find EBITDA and cash flow available for debt repayment over the investment horizon (typically 3 to 7 years). -Determine how much debt is repaid each year -Adjust balance sheet for new debt and equity -Estimate the multiple at which the sponsor is expected to exit the investment (should generally be similar to the entry multiple). -use the multiple to calculate exit value and subtract net debt for equity value -Calculate equity returns (IRRs) using excel with range of dates and range of equity values) -Solve for the price that can be paid to meet the above parameters (alternatively, if the price is fixed, solve for achievable returns). Good LBO candidate -Srong, predictable operating cash flows with which the leveraged company can service and pay down acquisition debt -Well-established business and products and leading industry position -Moderate CapEx and product development (R&D) requirements so that cash flows are not diverted from the principle goal of debt repayment -Limited working capital requirements -Undervalued or out-of-favor -Strong management team -Viable exit strategy Why would you use leverage when buying a company? -To boost your return. -Any debt you use in an LBO is not "your money" - so it's easier to earn a high return on $2 billion of your own money and $3 billion borrowed from elsewhere vs. $3 billion of your own money and $2 billion of borrowed money. -A secondary benefit is that the firm also has more capital available to purchase other companies because they've used leverage. What variables impact an LBO model the most? 1. Purchase and exit multiples have the biggest impact on the returns of a model. 2. The amount of leverage (debt) used also has a significant impact 3. Operational characteristics- revenue growth and EBITDA margins. Can you explain how the Balance Sheet is adjusted in an LBO model? 1. Liabilities adjusted - the new debt is added on. 2. Shareholders' Equity is "wiped out" and replaced by however much equity the private equity firm is contributing. 3. Assets side, Cash is adjusted for any cash used to finance the transaction, and then Goodwill & Intangibles are used to make the Balance Sheet balance. Depending on the transaction, there could be other effects as well - such as capitalized financing fees added to the Assets side. Why are Goodwill & Intangibles created in an LBO? -These both represent the premium paid to the "fair market value" of the company. -In an LBO, they act as a "plug" and ensure that the changes to the Liabilities & Equity side are balanced by changes to the Assets side. We saw that a strategic acquirer will usually prefer to pay for another company in cash - if that's the case, why would a PE firm want to use debt in an LBO? 1. The PE firm does not intend to hold the company for the long-term - it usually sells it after a few years, so it is less concerned with the "expense" of cash vs. debt and more concerned about using leverage to boost its returns by reducing the amount of capital it has to contribute upfront. 2. In an LBO, the debt is "owned" by the company, so they assume much of the risk. In a strategic acquisition, the buyer "owns" the debt so it is more risky for them. Do you need to project all 3 statements in an LBO model? Are there any "shortcuts?" Yes, there are shortcuts and you don't necessarily need to project all 3 statements. Balance Sheet: For example, you do not need to create a full Balance Sheet - bankers sometimes skip this if they are in a rush. --You can just make assumptions on the Net Change in Working Capital rather than looking at each item individually. Income Statement: You do need some form of Income Statement, something to track how the Debt balances change and some type of Cash Flow Statement: how much cash is available to repay debt. How would you determine how much debt can be raised in an LBO and how many tranches there would be? -Look at Comparable LBOs and see the terms of the debt and how many tranches each of them used. -Look at companies in a similar size range and industry and use those criteria to determine the debt your company can raise. What is the difference between bank debt and high-yield debt? High Yield Debt: • Higher interest rates • Interest rates are usually fixed • Has incurrence covenants • Entire principal is due at the end (bullet maturity) Bank Debt: • Interest rates are "floating" - they change based on LIBOR or the Fed interest rate. • Has maintenance covenants • Bank debt is usually amortized - the principal must be paid off over time Usually in a sizable Leveraged Buyout, the PE firm uses both types of debt. Maintenance vs incurrence covenant Incurrence covenants- prevent you from doing something (such as selling an asset, buying a factory, etc.) Maintenance covenants- require you to maintain a minimum financial performance (for example, the Debt/EBITDA ratio must be below 5x at all times). What is enterprise value Equity Value + Net Debt Equity Value+ (Debt- cash & cash equivalents) Value of all operating assets: Operating assets - operating liabilities Represents value available to common shareholders Why might you use bank debt rather than high-yield debt in an LBO? 1. The buyer is concerned about meeting interest payments and wants a lower-cost option, 2. They are planning on major expansion or Capital Expenditures and don't want to be restricted by incurrence covenants. Why would a PE firm prefer high-yield debt instead? 1. They intend to refinance the company soon 2. They don't believe their returns are too sensitive to interest payments 3. They don't have plans for major expansion or selling off the company's assets. How could a private equity firm boost its return in an LBO? 1. Lower the Purchase Price in the model. 2. Raise the Exit Multiple / Exit Price. 3. Increase the Leverage (debt) used. 4. Increase the company's growth rate (organically or via acquisitions). 5. Increase margins by reducing expenses (cutting employees, consolidating buildings, etc.). All "theoretical" and refer to the model not reality What is a dividend recapitalization ("dividend recap")? -The company takes on new debt solely to pay a special dividend out to the PE firm that bought it. -Metaphor: you make your friend take out a personal loan just so he/she could pay you a lump sum of cash with the loan proceeds. -Dividend recaps have developed a bad reputation, though they're still commonly used. Why would a PE firm choose to do a dividend recap of one of its portfolio companies? -Primarily to boost returns. -All else being equal, more leverage means a higher return to the firm. - With a dividend recap, the PE firm is "recovering" some of its equity investment in the company -The lower the equity investment, the better, since it's easier to earn a higher return on a smaller amount of capital. Walk me through DCF- Broad Assuming unlevered: 1. Determine free cash flow (FCF), equal to that period's operating cash flow minus capital ex . 2. Calculate a WACC using cost/market value of debt and equity 3. Do over period of 5-7 years, find each FCF and discount by the WACC, and add them all plus the terminal value 4. Calculate Terminal value either using the multiples method or growth in perpetuity method. 5. Add all that up to find enterprise value 6. Once you have enterprise value, subtract debt to get fair equity value 7. Divide equity value by number of shares outstanding for fair equity value per share 8. Compare our estimate to current stock price. If ours is higher, we might consider Company X a good investment. Walk me through how to do a DCF valuation (over specific) 1. Estimate future cash flow- determining the company's trailing twelve month (ttm) free cash flow (FCF), equal to that period's operating cash flow minus capital expenditures. -----Say that Company X's ttm FCF is $50 m. We would compare this figure to previous years' cash flows in order to estimate a rate of growth. ------Consider source of this growth. Are sales increasing? Are costs declining? 2. Say that you estimate that Company X's cash flow will grow by 10% in the first two years, then 5% in the following three. After a few years, you may apply a long-term cash flow growth rate, representing an assumption of annual growth from that point on. This value should probably not exceed the long-term growth prospects of the overall economy by too much; we will say that Company X's is 3%. 3. Calculate a WACC 4. Use WACC and Terminal Value formula to calculate Terminal value an present value of FCF 5. Use the terminal value and WACC and DCF formula to estimate enterprise value 6. Once you have enterprise value, subtract debt (money beholden to bondholder's) to get fair equity value 7. Divide equity value by number of shares outstanding for fair equity value per share 8. Compare our estimate to current stock price. If ours is higher, we might consider Company X a good investment. How would a dividend recap impact the 3 financial statements in an LBO? Income Statement: no changes Balance Sheet: Debt would go up and Shareholders' Equity would go down Cash Flow Statement: under Financing the additional Debt raised would cancel out the Cash paid out to the investors, so Net Change in Cash would not change. --no changes to Cash Flow from Operations or Investing Why would a private equity firm buy a company in a "risky" industry, such as technology? 1. It's fine-- There are mature, cash flow-stable companies in almost every industry. 2. Some PE firms specialize in very specific goals so even if a company isn't doing well or seems risky, the firm might buy it if it falls into one of these specialties. Name and explain 3 things a P/E firm might specialize in • Industry consolidation - buying competitors in a similar market and combining them to increase efficiency and win more customers. • Turnarounds - taking struggling companies and making them function properly again. • Divestitures - selling off divisions of a company or taking a division and turning it into a strong stand-alone entity. Purpose of DCF Estimate the money an investor would receive from an investment, adjusted for the time value of money. Assumptions of DCF (what does it say about a productive asset) • The value of a productive asset equals the present value of its cash flows. • Answer should run along the line of "project free cash flows for 5-7 years, depending on the availability and reliability of information . How do you know if your DCF is too dependent on future assumptions? -If significantly more than 50% of the company's Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions. -In reality, almost all DCFs are "too dependent on future assumptions" What should you do if you don't believe management's projections for a DCF model? You can take a few different approaches: • Create your own projections. • Modify management's projections downward to make them more conservative. • Show a sensitivity table based on different growth rates and margins and show the values assuming managements' projections and assuming a more conservative set of numbers. You'd probably do all of these Why would you not use a DCF for a bank or other financial institution? (two reasons) Two reasons: 1. Banks use debt differently than other companies and do not re-invest it in the business - they use it to create products instead. 2. Interest is a critical part of banks' business models and working capital takes up a huge part of their Balance Sheets - so a DCF for a financial institution would not make much sense. More common to use a dividend discount model for valuation purposes define terminal value -long-term valuation of the company's growth approaches -Assumes that the business will be valued at the end of the projection period, based on public markets valuations What do we use as the discount rate for unlevered weighted average cost of capital (WACC) as the discount rate. two ways to calculate terminal value 1. Perpetuity growth= FCF* (1 + long-term growth rate) / (WACC- long-term growth rate) --grow at 2-4% not exceed growth of economy --assumes FCF in last year grows at a constant rate indefinitely 2. Exit multiple method= Multiple * Financial Metric --Assumes company is worth a multiple of an operating method --Use company LTM multiple, or the one of trading comps --should reflect steady state growth and margins Terminal value formula-- Exit Multiple method TV = LTM Terminal Multiple × Statistic projected for the last 12 months of the projection period Terminal value formula-- Perpetuity Growth FCF* (1 + long-term growth rate) / (WACC- long-term growth rate) Which method for calculating terminal value is more common? Why Almost always use the Multiples Method to calculate Terminal Value in a DCF. -- easier to get exit multiples based on Comparable Companies - than to pick a long-term growth rate, by contrast, is always a shot in the dark. Why would you use Gordon Growth rather than the Multiples Method to calculate the Terminal Value? 1. You have no good Comparable Companies 2. You have reason to believe that multiples will change significantly in the industry several years down the road. ---Ex: if an industry is very cyclical you might be better off using long-term growth rates rather than exit multiples. What's an appropriate growth rate to use when calculating the Terminal Value? Something conservative: country's long-term GDP growth rate, the rate of inflation, or something similarly conservative. Talk about Exit multiple method generally -Usually use (EV/EBITDA, EV/EBIT, etc.) to the relevant statistic projected for the last projected year. -Since the DCF values cash flow available to all providers of capital, use EV multiples not equity value multiples. -usually developed based on selected companies' trading multiples. being applied to the statistic projected for the last projection year, How do you select the appropriate exit multiple when calculating Terminal Value? -You look at the Comparable Companies and pick the median of the set, or something close to it. -Show a range of exit multiples and what the Terminal Value looks like over that range rather than picking one specific number. -Ex: median EBITDA multiple of the set were 8x, you might show a range of values using multiples from 6x to 10x. Which method of calculating Terminal Value will give you a higher valuation? Multiples Method- more variable than the Gordon Growth method because exit multiples tend to span a wider range than possible long-term growth rates. Talk about Perpetuity Growth generally -assumes that the company will continue its historic business and generate FCFs at a steady state forever -The perpetuity growth rate is typically between the historical inflation rate of 2-3% and the historical GDP growth rate of 4-5%. -not used often b/c it's hard to estimate the perpetuity growth rate and determine when the company achieves steady-state. -can be used to check exit multiple What does it mean if someone models perpetuity growth as greater than 5% that you expect the company's growth to outpace the economy's growth forever. unlevered vs. levered cash flows Unlevered Free Cash Flow excludes Interest and thus represents money available to all shareholders Levered already includes Interest and the money is therefore only available to equity shareholders. Debt investors have already "been paid" with the interest payments they received. What is WACC -the minimum acceptable rate of return at which a company yields returns for its investors - Value of a business is the sum of all the cash flows it will generate, discounted to the present value using a discount rate that reflects the riskiness of the business. -reflects the riskiness of a private or publicly traded company for providers of capital, including debt and equity holders. -For this reason, the numerator in the equation represents free cash flows before any interest or debt payments, aka unlevered free cash flows. WACC formula [ Rd(1-CTR) debt/(debt +equity)] + [Re*equity/debt+equity] What does it mean when a company yields returns of 20% and has a WACC of 11%? Means the company is yielding 9% returns on every dollar the company invests. In other words, for each dollar spent, the company is creating nine cents of value. What does it mean when a company yields returns of 11% and has a WACC of 17%? -the company is losing six cents for every dollar spent -may not be a very good investment Should Cost of Equity be higher for a $5 billion or $500 million market cap company? - $500 million company, because all else being equal, smaller companies are expected to outperform large companies in the stock market (and therefore be "more risky"). -Using a Size Premium in your calculation would also ensure that Cost of Equity is higher for the $500 million company.