BIWS Valuation Questions and Answers

BIWS Valuation Questions and Answers What are the three major valuation methodologies? Public company comparables (public comps), Precedent transactions and discounted cash flow analysis. Public comps and precedent transactions are examples of relative valuation, while DCF analysis is intrinsic valuation. Walk me through how you use Public comps and Precedent transactions First you select the companies and transactions based on criteria such as industry, financial metrics, geography. Then you determine the appropriate metrics and multiples for each set (revenue, revenue growth. EBIT, EBITDA). Next you calculate the minimum 25th percentile, median, 75th percentile, and maximum for each valu8ation multiple set, Finally, you apply those numbers to the financial metrics for the company you're analyzing to estimate the potential range for its valuation How do you select comparable companies or precedent transactions the 3 main criteria for selecting companies and transactions: 1. industry classification 2. financial criteria (revenue, EBITDA) 3. geography For precedent transactions, you also limit the set based on date and often focus on 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 For public comps, you calculate equity value and enterprise value for use in multiples based on companies' share prices and share counts but what about for precedent transactions? How do you calculate multiples there? They should be based on purchase price of the company at the time of the deal announcement. You only care about what the offer price was at the initial deal announcement. How would you value an apple tree? Same way you would value a company: by looking at what comparable apple trees are worth (relative valuation) and the present value of the apple tree's cash flows (intrinsic valuation) When is DCF useful? When is it not useful? A DCF is best when the company is large, mature, and has stable and predictable cash flows. (fortune 500 companies). Your far-in-the-future assumptions will generally be more accurate there. A DCF is not as useful if the company has unstable or unpredictable cash flows (start-up) or when Debt and operating assets and liabilities serve fundamentally different roles What other valuations methodologies are there? Liquid valuation- valuing a company's asset, assuming they are sole off and then subtracting liabilities to determine how much capital, if any, equity investors receive 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 Parts- valuing each division of a company separately and adding them together at the end M&A Premium 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 and then discounting it back to its present value When is a liquidation valuation useful? It's most common in bankruptcy scenarios and is used to see whether or not shareholders will receive anything after the company's liabilities have been paid off with the proceeds from selling all its Assets. It is often used to advise struggling businesses on whether it's better to sell off assets separately or to sell 100% of the company When would you use a Sum of the Parts valuation? This is used when a company has completely different, unrelated divisions - a conglomerate like GE, for example. If you have unrelated divisions 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 calculate the total value When do you use an LBO analysis as part of your valuation? Clearly, whenever your analyzing a leveraged buyout - but it is also used to "set a floor" on the company's value and determine the minimum amount that a PE firm could pay to achieve its targeted returns. You often see it used when both strategics (normal companies) and financial sponsors (PE firms) are competing to buy the same company, and you want to determine the potential price of a PE firm were to acquire the company How do you apply the valuation methodologies to value a company Present everything in a "Football Field" graph. To do this, you need to calculate the minimum, 25th percentile, median, 75th percentile, and maximum for each set and then multiply by the relevant metrics for the company you're analyzing Walk me through how to calculate EBIT and EBITDA? How are they different? EBIT is just a company's OPy in its IS; and it includes not only COGS and OPex, but also non-cash charges such as depreciation and amortization and therefore reflects, at least indirectly, the company's Capex. EBITDA is defined as EBIT plus depreciation plus amortization. You may sometimes add back other expenses as well. The idea of EBITDA is to move closer to a company's "cash flow" since D&A are both non-cash expenses but there's a problem with that since you're also excluding Capex. What about how you calculate Unlevered FCF (to firm) and Levered FCF (to equity) There are several methods, but the simplest ways: Unlevered FCF = EBIT x (1-tax rate) + Non-cash charges - change in operating assets and liabilities - Capex With unlevered FCF, you're excluding interest income and expenses, as well as mandatory debt repayments Levered FCF = NI + Non-cash charges - change in operating assets and liabilities - Capex - Mandatory repayments With levered FCF, you're including interest income, interest expense, and required principal repayments on the debt What are the most common valuation multiples and what do they mean? EV/ Revenue: how valuable is a company in relation to its overall sales EV/ EBITDA: How valuable is a company in relation to its approximate cash flow EV/ EBIT: How valuable a company is in relation to the pre-tax profit it earns from its core business operations PPS/EPS (P/E): How valuable is a company in relation to its after-tax profits, inclusive of interest income and expense and other non-core business activities. How are the key operating metrics and valuation multiples correlated? In other words, what might explain a higher or lower EV/EBITDA multiple? Usually, there is a correlation between growth and valuation multiples. So if one company is growing revenue or EBITDA more quickly, its multiples for both of those may be higher as well. Keep in mind that plenty of other non-financial factors explain higher or lower multiples Why can't you use equity value/EBITDA as a multiple rather than EV/EBITDA? If the metric includes interest income and expense, you use equity value; if it excludes them you use enterprise value. What would you use with Free cash flow multiples - Equity value or Enterprise value? Trick question. For unlevered FCF, you would use enterprise value, but for levered FCF you would use equity value. Unlevered FCF excludes interest (and mandatory debt repayments) and thus represents money available to all investors, whereas levered FCF already includes the effects of interest expense (and mandatory debt repayments) and the money is therefore only available to equity investors Why does Warren Buffet prefer EBIT multiples to EBITDA multiples? He dislikes EBITDA because it hides the Capex companies make and disguise how much cash they require to finance their operations. In some industries there is also a large gap between EBIT and EBITDA. EBIT itself does not include Capex, but it does include depreciation and that is directly linked to Capex What are some problems with EBITDA and EBITDA multiple? And if there are so many problems, why do we still use it? First, it hides the amount of debt principal and interest that a company is paying each year, which can be very large and may make the company cash flow-negative; it also hides Capex spending. EBITDA also ignores working capital requirements (AR, AP), which can be very large for companies. Finally, companies like to add back many charges and expenses to EBITDA, so you never really know what it represents unless you dig into it. Not really close to true cash flow, just widely used for convenience. Better used for comparing the cash generated by a company 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 insurance firms, and other companies where interest is critical and where capital structures tend to be similar. 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 Capex and fixed assets are important, and EV/EBITDA in industries where fixed assets are less important and where D&A is smaller. Could EV/EBITDA ever be higher than EV/EBIT for the same company? No. EBITDA must be greater than or equal to EBIT because to calculate it, you take EBIT and then add depreciation and amortization, neither of which can be negative (but could be $0). Since EBITDA is always greater than or equal to EBIT, EV/EBITDA must always be less than or equal to EV/EBIT for a single company What are some examples of industry-specific multiples? Tech: EV/unique visitors, EV/Pageviews Retail/Airlines: EV/EBITAR Oil & Gas: EV/EBITDAX When you're looking at an industry specific multiple like EV/Proved reserves or EV/subscribers, why do you use enterprise value rather than equity value? You use enterprise value because those proved reserves or subscribers are "available" to all the investors (both debt and equity) in a company. This is almost always the case unless the metric already includes interest income and expense Rank the 3 main valuation methodologies from highest to lowest expected value trick question - there is no ranking that always holds up. In general, precedent transactions will be higher than public comps due to the control premium paid, beyond that a DCF could go either way. Would an LBO or DCF produce higher valuation? Technically it could go either way, but in most cases the LBO will give you a lower valuation. Unlike the a DCF, an LBO model by itself does not give a specific valuation. Instead, you set a desired IRR and back=solve for how much you could pay for the company based on that When would a liquidation valuation produce the highest value? Highly unusual, but it could happen if a company had substantial hard assets but the market was severely undervaluing it for a specific reason. As a result, the comparable companies and precedent transactions would likely produce lower values as well Why are public comps and precedent transactions sometimes viewed as being "more reliable" than a DCF? They're based on actual market data, as opposed to assumptions far into the future, even though you still do make future assumptions with these. What are the flaws with public comps? 1. no company is 100% comparable to another company 2. the stock market is "emotional" - your multiples might be dramatically higher or lower on certain dates depending on market movement 3. share prices for small companies with thinly-traded stocks may not reflect their full value What is a case where precedent transactions would not produce a higher value? When there is a substantial mismatch between the M&A market and public markets. Ex: no public companies have been acquired recently but lots of small private companies have been acquired at low valuations. What are some flaws with precedent transactions 1. past transactions are rarely 100% compatible - the transaction structure, sixe of the company, and market sentiment all make a huge impact 2. data on precedent transactions is generally more difficult to find than it is for public company comps, especially for small private acquisitions Why would a company with similar growth and profitability to its comparable companies be valued at a premium? 1. company has just reported earnings well above expectations and its stock price has risen in response 2. it has some type of competitive advantage not reflected in its financials, such as a key patent or other intellectual property 3. It has just won a favorable ruling in a major lawsuit 4. It is the market leader in an industry and has greater market shares than its competitors How do you take into account a company's advantages in a valuation? 1. highlight the 75th percentile or higher for the multiples rather than median 2. add in a premium to some of the multiples 3. use more aggressive projections for the company Do you always use the median multiple of a set of public company comparables or precedent transactions? No. You must always use the range and you may make the median the center of that range but you can focus on any percentile Two Companies have the exact same financial profiles and are purchased by the same acquirer, but the EBITDA multiple for one transaction is twice the multiple of the other transaction - how could this happen 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 4. The two companies have different accounting standards and have added back different items when calculating EBITDA, so the multiples are not truly comparable If you were buying a vending machine, would you pay a higher EBITDA multiple for a business that owned the machines and where they depreciated them normally, or one in which the machines were leased? The Depreciation expense and the lease expense are the same dollar amounts and everything else is held constant You would pay a higher multiple for the one with leased machines if all else is equal. The purchase enterprise value would be the same for both acquisitions, but depreciation is excluded from EBITDA - so EBITDA is higher, and the EV/EBITDA multiple is lower for the one that owns its own machines. For the company with leased machines, the lease expense would show up in OPex, making EBITDA lower and the EV/EBITDA multiple higher How would you value a company that has no profits and no revenues? 1. could use comparable companies and precedent transactions and look at more creative multiples 2. could use a far in the future DCF and project a company's financials out until it actually earns revenue and profit The S&P 500 Index has a median P/E multiple of 20x. A manufacturing company you're analyzing has earnings of $1M. How much is the company worth? It depends on how its performing relative to the index, and relative to companies in its own industry. If it has higher growth and margins, you may assign a higher multiple to it - maybe 25x or even 30x, and therefore assume that its equity value equals $25M or $30M. If its on par with everyone else, then maybe its valuation is just $20M A company's current stock price is $20.00 per share, and its P/E multiple is 20x, so its EPS is $1.00. It has 10M share outstanding, now it does a 2 for 1 stock split - how do its P/E multiple and valuation change They don't. Share price falls to $10 and its EPS falls to $0.50, so the P/E multiple remains 20x. Stock split is usually a positive sign by the market Let's say that you're comparing a company with a strong brand name, such as Coca-Cola, to a generic manufacturing or transportation company. Both companies have similar growth profiles and margins. Which one will have the higher EV/EBITDA multiple? In all likelihood, Coca-Cola will have the higher multiple due to its strong brand name.