IB Prep - Valuation Qs Questions and Answers

IB Prep - Valuation Qs Questions and Answers What are the 3 major valuation methodologies? Comparable companies, precedent transactions, and discounted cash flow analysis. 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. 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, for example) 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 sheet--so you wouldn't use a DCF for such companies. What other valuation methodologies are there? Other methodologies include: - 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, and rent). Energy: P/MCFE, P/MCFE/D (MCFE = 1 million cubit 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-recurring, so FFO is viewed as a "normalized" picture of the cash flow the REIT is generating. When you're looking at an industry-specific multiple like EV/Scientists of EV/Subscribers, why do you use enterprise value rather than equity value? You use enterprise value because those scientists of 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 multiples 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. 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 an 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. Note: this is a very common wrong answer given by interviewees. When you can't predict cash flows, 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 cash flow, you would use equity value. Note: 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 would never use equity value/EBITDA, but are there 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 non-financial 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: CC: Oil & gas producers with market caps over $5 billion. CC: Digital media companies with over $100 million in revenue. PT: Airline M&A transactions over the past 2 years involving sellers with over $1 billion in revenue. PT: 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 leader in an industry and has a greater market share than its competitors. What are 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 a 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 the 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, sometimes M&A activity will be primarily focused on small private companies who are acquired at extremely low valuations, rather than large public companies. What are some flaws with precedent transactions? - Past transactions are rarely 100% comparable--the transaction structure, size of 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 Buffet prefer EBIT multiples to EBITDA multiples? Warren Buffet once famously said, "Does management think the tooth fairy pays for capital expenditures? He dislikes EBITDA because it excludes the often sizeable 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 and 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 situations, 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 the 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 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. How do you value banks and financial institutions differently from other companies? You mostly use the same methodologies, except: - You look at P/E and P/BV multiples rather than EV/Revenue, EV/EBITDA, and other "normal" multiples since banks have unique capital structures. - You pay more attention to bank-specific metrics like NAV (Net Asset Value) and you might screen companies and precedent transactions based on those instead. - Rather than a DCF, you use a Dividend Discount Model (DDM) which is similar but is based on the present value of the company's dividends rather than its free cash flows. You need to use these methodologies and multiples because interest is a critical component of a bank's revenue and because debt is part of its business model rather than just a way to finance acquisitions or expand the business. Walk me through an IPO valuation for a company that's about to go public. 1. Unlike normal valuations, for an IPO valuation we only care about public company comparables. 2. After picking the public comparables, we decide on the most relevant multiple to use and then estimate our company's enterprise value based on that. 3. Once we have the enterprise value, we work backwards to get to equity value and also add the IPO proceeds because this is "new" cash. 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" for the multiple in step 2 here, then you would get to equity value instead and then add the IPO proceeds from there. Walk me through an M&A premiums analysis. The purpose of this analysis is to look at similar transactions and see the premiums that buyers have paid to sellers' share prices when acquiring them. For example, if a company is trading at $10/share and the buyer acquires it for $15/share, that's a 50% premium. 1. First, select the precedent transactions based on industry, date (past 2-3 years for example), and size (example: over $1 billion market cap). 2. For each transaction, get the seller's share price day 1, 20 days, 60 days before the transaction was announced (you can also look at even longer intervals). 3. Then, calculate the 1-day premium, 20-day premium, etc. by dividing the per-share purchase price by the appropriate share prices 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, etc. to estimate how much of a premium a buyer might pay for it. Note that you only use this analysis when valuing public companies 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. 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 TTM) P/E of your 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 back to its present value by using a discount rate in-line with the company's cost of equity figures. You normally look at a range of P/E multiples as well as a range of discount rates for this type of analysis, and make a sensitivity table with these as inputs. Both M&A premiums analysis and precedent transactions involve looking at 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. The industry and financial screens are usually less stringent. - Aside from those, the screening criteria is similar--financial, industry, geography, and date. 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: We have a manufacturing division with $100 million EBITDA, an entertainment division with $50 million EBITDA, and a consumer goods division with $75 million EBITDA. We've selected comparable companies and transactions for each division, and the median multiples come out to 5x EBITDA for manufacturing, 8x EBITDA for entertainment, and 4x EBITDA for consumer goods. Our calculation would be $1005+508+75*4=$1.2 billion for the company's total value. How do you value net operating losses and take them into account in a valuation? You value NOLs based on how much they'll save the company in taxes in future years, and then take the present value of the sum of the tax savings in future years. Two ways to assess 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 adjusted long-term rate ( You might look at NOLs in a valuation but you rarely add them in--if you did, they would be similar to cash and you would subtract NOLs to go from equity value to enterprise value, and vise versa.