1
Q
Valuation: Core Purpose?
A
Calculate Co’s IMPLIED Value and compare it w/ Co’s CURRENT value
- current value = markets could be wrong. value co’s to see if market is wrong.
- make recommendations to buy or not to buy a co (undervalued vs. overvalued)
- sell-side: what you can expect to get if you sell
2
Q
Why is valuation more complicated than the simple formula of Company Value = Cash Flow / (Discount Rate - CF Growth Rate)?
A
In reality, the Discount Rate & CF Growth rate change over time.
3
Q
What are 2 ways to more accurately value a company? (As compared to simple Company Value formula)
A
1) DCF Analysis: Valuing a co based on its CFs (often called intrinsic valuation)
2) Relative Valuation: Use valuation multiples
4
Q
Discounted Cash Flow Analysis - what is it?
A
Valuing a co based on its CFs; this method is often called intrinsic valuation.
1) PROJECT CO’S CASH FLOWS in detail in explicit forecast period (usually next 5-15 years) (future). –> Discount these CFs to their Present Value ==> Add them up.
2) Then, assume the Co’s CF Growth Rate & Discount Rate stay the same in the TERMINAL PERIOD –> Find Terminal Value: value the CO in THAT TERMINAL PERIOD using the Company Value Formula = Cash Flow / (Discount Rate - CF Growth Rate) ==> Discount Co’s Terminal Value to its PV
3) Add PV of Terminal Value to Discounted CFs from first 5-15 years ==> = Implied Value of Co
5
Q
What is the most THEORETICALLY correct way to value a co?
A
DCF - b/c valuing co based on its CFs, rather than external factors like other companies ==> often called “intrinsic valuation”
6
Q
Relative Valuation - what is it?
A
Use VALUATION MULTIPLES for the company’s near-term financial results (ex: next 1-2 years) & don’t rely on long-term CF projections.
–> Valuation Multiples = shorthand for CF-based valuation
To use: 1) collect set of “comparable” companies and M&A transactions –> 2) calculate their valuation multiples –> 3) apply multiples to the co you are valuing
7
Q
What type of CF to use in DCF?
A
Usually should use UNLEVERED FCF
- if you use unlevered -> DCF produces EV
- if you use levered -> DCF produce EqV, rather than EV
8
Q
Unlevered Free Cash Flow (UFCF) - What is it/what does it represent? Advantages over other types of FCF?
A
UFCF = represents discretionary CF avail from core business to ALL investors.
2 main advantages over other types of FCF:
1) CONSISTENCY: UFCF does not depend on co’s capital structure => will get same results even if co issues Debt, Equity, repays Debt, etc.
2) EASE OF PROJECTING: Ignore Net Income Expense in the analysis ==> so, don’t need to project items like Debt, Cash, interest rates on Debt & Cash –> less research, faster conclusion
9
Q
Unlevered FCF - What items should it consist of? What items to ignore & why?
A
UFCF = represents discretionary CF avail from core business to ALL investors.
Consists of:
1. (ADD) Revenue
2. (DEDUCT) COGS & Operating Expenses (deduct full Lease Expense as well!)
3. (DEDUCT) Taxes
4. (ADD) Depreciation & amoritization (and sometimes other non-cash add-backs)
5. (ADD OR DEDUCT) Change in Working Capital
6. (DEDUCT) Capital Expenditures
IGNORE: 1) Non-recurring items or 2) items that relate only to specific investor groups, rather than ALL investors.
(–> So, ignore: Net Interest Expense, Other Income / (Expense), MOST of the non-cash adjustments, CF from Financing section, most of CF from Investing section)
10
Q
What “Non-Cash Adjustments” on CFS are included vs. excluded from Unlevered FCF?
A
- D&A is included. Sometimes Deferred Income Taxes are included, but not much else.
- MOST of non-cash adjustments are excluded b/c:
1) Most of them are non-recurring (ex: Gains & Losses, Impairments, Write-Downs). ==> So, when you PROJECT FCF: ignore non-recurring items in the future; or
2) Stock-based compensation (common, recurring item in non-cash adj section) = NOT a real non-cash expense & relates only to a specific investor group (common SHs)
11
Q
Stock-based compensation (SBC) - is it a true non-cash expense?
A
No b/c it creates additional shares –> dilutes existing investors. ==> So, still costs you money)
==> So, can’t add SBC back to Unlevered FCF as non-cash expense. (Otherwise, not reflecting existing SHs’ reduced ownership in the Co)
12
Q
Interest Expense and Other Expense / (Income) - why is it ignored in UFCF formula?
A
They’re only available to certain investor groups
13
Q
Discount Rate - definition; implications of higher/lower Discount Rate
A
Discount Rate = Opportunity cost for investor: what they could earn by investing in other, similar companies
Higher Discount Rate = implies higher risk/potential returns; makes co LESS valuable - b/c means investor has better options elsewhere
Lower Discount Rate = implies lower risk/potential returns; makes co MORE valuable - b/c means investor has worse options elsewhere
14
Q
Why do companies have multiple Discount Rates?
What are most impt Discount Rates for valuation/DCF purposes?
A
- Since co’s have multiple sources of capital (can invest in a co in diff ways: buy its shares, bonds, Preferred Stock, other securities) –> multiple Discount Rates ==> each part of capital structure has diff rate
- Most important Rates:
1) Cost of Equity: “opportunity cost” for common stock - what investors can earn from a) stock price increases & b) dividends
2) Cost of Debt: for co’s outstanding debt - represents “yield” investors can earn from a) interest payments and b) diff bt market value of debt & amount co will repay upon maturity
3) Preferred Stock: for Preferred Stock - similar to Cost of Debt (but Preferred Stock tends to have higher coupon rates & Preferred Dividends also are not tax-deductible)
15
Q
Weighted Average Cost of Capital (WACC) - definition/intuition; formula; why does it always pair w/ unlevered FCF?
A
WACC = Cost of Equity * % of Equity + Cost of Debt * % of Debt * (1 - Tax Rate) + Cost of Preferred Stock * % of Preferred Stock
WACC = represents OVERALL Discount Rate for entire company
-If you invest proportionally in co’s entire capital structure –> WACC = expected, long-term annualized return
- to a co: WACC = cost of funding its operations by using ALL its sources of capital & keeping its cap structure %s the same over time
–> always pairs w/ UFCF b/c both represent ALL investors in the co
- investors: might invest in a co if its expected IRR exceeds WACC, and a co might decide to fund a new project, acq, or expansion if its expected IRR exceeds WACC
16
Q
Cost of Debt & Cost of Preferred Stock: What do these rates represent? How to approximate?
A
Represents rates would pay if it issued ADDITIONAL Debt or Preferred Stock.
*can estimate:
- calculate weighted avg coupon rate on existing debt/pref stock
- median coupon rate on oustanding issuances of comparable public companies
==> Can’t predict, but can approximate: look at co’s current Debt & Preferred Stock
1) Coupon rate(s) –> approximate for Pre-Tax Cost of Debt
2) YTM
3) Risk-free Rate + “default spread” based on co’s expected credit rating after it issues additional debt
**
- look at comparable co’s / debt issues & int rates & yields issued by similar co’s to get estimates
17
Q
Cost of Debt & Cost of Preferred Stock: Market Value vs. Face Value
A
18
Q
Cost of Equity - definition; how to estimate - GENERAL
A
Represents how much a co’s stock “should” return each year, on avg, over long-term, factoring in both 1) stock-price appreciation and 2) dividends
- co “pays” for equity in 2 ways:
1) gives up stock appreciation rights to other investors (losing some of upside - non-cash expense)
2) issuing dividends (cash expense)
To estimate: usually use Capital Asset Pricing Model (CAPM) –
Cost of Equity = Risk Free Rate + Equity Risk Premium * Levered Beta
–> estimates co’s expected return b/c difficult in practice to est impact of both of these
19
Q
Risk-Free Rate - definition; how to calculate
A
- Represents what you can earn (interest rate) on “riskless security” (“safe” govt bonds)
- usually, look at yields of 10 year government bonds (or 20 year bonds) in country of same currency as co’s CFs
- IF govt bonds in the co are NOT risk-free (ex: Greece): take Rf Rate from country that is (Ex: US, UK) & add a default spread based on co’s credit rating
–> intuition: add the default spread to show risk that this govt has a higher change of defaulting
20
Q
Levered Beta - definition; how to calculate
A
Represents VOLATILITY of this stock relative to the market as a whole; reflects risk of both 1) co’s intrinsic business risk and 2) risk introduced by leverage (Debt)
Ex: If Beta = 1 –> when market goes up 10%, co’s stock goes up 10%.
Ex: If Beta = 0.5 –> when market goes up 10%, co’s stock goes up 5%
To calculate:
1) Easy Method = HISTORICAL Beta: based on co’s price history (stock performance vs. relevant index); or
2) Harder Method = Analyze comparable companies
- WHY?: 1) get proper range of values for COE => leads to range for WACC too and 2) point of valuation is to determine Co’s IMPLIED Value (contra: co’s past performance = more in line w/ Current Value)
*When you look up a co, it is already LEVERED: co’s previous stock price movements already priced in (reflects) the co’s debt they’ve taken on
21
Q
Equity Risk Premium - how to calculate for multinational co in many geographies?
A
22
Q
Equity Risk Premium - definition; how to calculate
A
- Represents percentage the stock market will return each year, on avg, above yield on “safe” govt bonds
–> EXTRA yield you can early by investing in an index that tracks stock market
–
To calculate: ALWAYS linked to company’s country & domestic stock market.
BUT 3 points of disagreement on how to calculate –
1) Historical vs. Projected numbers? – Projected ones make more sense, but how to “project” stock market?
2) Arithmetic vs. geometric mean?
3) Period?
==> Pick reasonable range of values (look at a few data sources), rather than argue for single #
–
- can take historical data from US stock market + add a premium based on default spread in a specific co
- some groups also use a standard # for each market (ex: 5-6% in developed countries)
23
Q
Beta - intuition
A
- beta measures a co’s “risk” (compared to rest of the market
- Beta represent 2 types of risk:
1) inherent BUSINESS risk
2) risk from DEBT (leverage)
(ex: defaulting on debt; not being able to pay interest)
24
Q
Beta - intuition behind using using comparable companies beta vs. historical beta?
A
- assumption that co’s “true” riskiness = more in-line w/ how risky similar co’s in the market are, than to its own historical track record
–> figuring out what a co’s beta SHOULD be, rather than what it currently is - in a valuation, trying to est a co’s implied value - what it should be worth.
- using historical beta corresponds more closely w/ co’s CURRENT value
25
Beta - Comparable Companies Analysis: How to calculate?
*intuition behind calculation: Since Beta reflects both 1) inherent business risk & 2) risk from leverage --> can't just use median Beta from comparable companies b/c each comparable co has a diff capital structure --> so, risk from leverage will also be diff.
=> So, have to remove risk from leverage to ISOLATE INHERENT BUSINESS RISK of comparable companies.
To calculate:
1) Have to find UNLEVERED Beta for all comparable companies (reduce Beta by removing risk from leverage)
2) Calculate median Unlevered Beta
2) Then, have to RE-LEVER Beta --> to reflect risk from leverage of the co you're valuing.
==> BUT: What Capital Structure to use?
26
How to UNLEVER Beta? - formula
Unlevered Beta = Levered Beta / (1 + Debt/Equity * (1-Tax Rate) + Preferred/Equity)
*trying to remove additional risk from debt w/ this calculation
- denom = “Let’s assume that this risk from Debt is directly proportional to the company’s Debt / Equity ratio. But remember that interest paid on Debt is also tax-deductible, and as a result that helps reduce the risk from Debt slightly, since we save on taxes.”
27
How to RE-LEVER Beta?
Levered Beta = Unlevered Beta * (1 + Debt/Equity * (1-Tax Rate) + Preferred/Equity)
28
Cost of Equity Formula: Capital Structure - Current vs. Optimal or Targeted
*BACKGROUND LOGIC: Don't necessarily want to use co's CURRENT capital structure (b/c trying to figure out implied VALUE) => USE "Optimal Capital Structure" or "targeted Capital Structure"
"Targeted Capital Structure" = what co plans to use
"Optimal Capital Structure" = mix of Debt, Equity, and Preferred Stock that minimizes WACC
IRL:
1) No co discloses their planned capital structures and hard to know cap structure will definitely change in certain, predictable way
2) "Optimal capital structure" = impossible to observe or calculate (can't tell in advance what this co's cap structure SHOULD be, not what it is right now)
--> So, to estimate "optimal" or "targeted" structure:
1) Find median capital structure percentages of comparable companies and
2) Apply them to your co
29
Cost of Equity: Diff methods (to establish a RANGE of Values)
Differs based on: 1) Historical Beta vs. Comp Companies Beta used and 2) Capital Structure used
1) COE based on Levered Beta from comparable companies & co's current capital structure.
2) COE based on Levered Beta from comp companies & "optimal" capital structure
3) (EASY METHOD) COE based on co's historical levered beta & current capital structure
30
What makes WACC tricky to calculate?
1) CAPITAL STRUCTURE: Can use either a) Co's current capital structure or b) optimal/targeted cap structure for %s of Equity, Debt, Preferred Stock
2) COST OF EQUITY CALCULATION: Diff methods to calculate
3) EQUITY RISK PREMIUM: disagreements on how to calculate
4) COST OF DEBT & COST OF PREFERRED STOCK CALCULATION: Diff methods to calculate
==> Should focus on finding plausible range of values for WACC, rather than single number
31
Discounting Cash Flows: Should you use same discount rate (WACC) every year?
Discount each year's UFCF to PV using formula: PV = Cash Flow / ((1 + Discount Rate)^Year #)
--> Co's risk profile could change over time ==> so may not want to use same discount rate every year.
- IF Co grows & matures significantly in explicit forecast period => reasonable to start w/ higher Discount Rate --> gradually move to lower one
- IF Co is 1) mature & not expected to change significantly in the future and 2) other mature co's in industry have WACCs in similar range => reasonable to use same WACC every year
32
Terminal Value - definition; ways to calculate
Co's value in far-future period (Terminal Period)
2 methods to calculate:
1) Perpetuity Growth Method or Gordon Growth Method
2) Multiples Method
*the PV of the co's FCFs from the final year into infinity, as of the final year.
33
Perpetuity Growth/Gordon Growth Method - formula & intuition behind formula
One way to calculate Terminal Value:
Terminal Value = Unlevered FCF in Year 1 of Terminal Period / (WACC - Terminal Unlevered FCF Growth Rate)
*LOGIC:
--> in Terminal Period, assume that co's Discount Rate & CF Growth Rate stay the same
--> But, CF keeps changing: Unlevered FCF in Y1 of Terminal Period ==> project UFCF 1 year AFTER explicit forecast period (usually = (1 + Terminal UFCF Growth Rate) * Last UFCF in forecast period))
==> Terminal Value = Final Forecast Year UFCF * (1 + Terminal UFCF Growth Rate) / (Discount Rate - Terminal UFCF Growth Rate)
*Intuition:
- growth (on the CFs) increases returns, so increases what you can "afford" to pay NOW & still get the return you require
--> the higher the expected GROWTH, the more you can pay up front.
- if expected growth is the same as the required return, theoretically you can pay an infinite amount to achieve that return
34
Terminal UFCF Growth Rate
- Should be LOW - below long-term GDP growth rate of country (and perhaps in-line w/ rate of inflation)
- Even if co grows at a higher rate initially --> growth always slows down over time.
=> Should be fairly close to UFCF growth rate at the end of explicit forecast period
35
Terminal UFCF Growth Rate: Developed vs. Emerging Markets
- In developed/mature markets (ex: U.S., U.K., Canada) --> should use %s in low single digits (1-3%)
- In emerging markets (ex: China, India) --> still shouldn't use a dramatically higher number
(B/c: even if market is growing aggressively right now, 1) rate will decrease eventually and 2) individual co's will grow at lower rates in the long-term)
36
Multiples Method - what is it? how to calculate? flaw?
Way to calculate Terminal Value:
Terminal Value = Terminal EBITDA or EBIT or NOPAT or UFCF Multiple * Relevant Metric
- apply exit multiple to co's last year of the forecast period's EBITDA, EBIT or FCF
*flaw = median multiples can change in next 5-10 years -> may not be accurate by end of period
37
Multiples Method: Terminal Multiple - how to pick?
- Base on multiples of publicly traded co's
- BUT: Sometimes apply a DISCOUNT - b/c as co's growth rates slow over time --> multiples also tend to decrease
--> BUT BUT: For CYCLICAL industries --> valuation multiples tend to increase/decrease over time
==> (-) Tricky to pick "correct" Terminal Multiples
(Recommend: start w/ Perpetuity Growth Method & use Implied Multiple to check => Look at implications for Terminal Growth Rate)
Ex: If Terminal Growth Rate too high --> need to pick a lower multiple so that implied Growth Rate makes sense
38
Multiples Method vs. Gordon Growth Method - which to use?
- (-) both are difficult to determine precisely
- easier to get data for multiples method
- cyclical industry or multiples harder to predict (believe multiples will change significantly in several years) or no comparable companies --> gordon growth
- multiples easier to predict --> multiples method
39
Multiples Method: How to back into Implied Growth Rate?
Implied Terminal FCF Growth Rate = (Terminal Value * Discount Rate - Final Year FCF) / (Terminal Value + Final Year FCF)
40
Discounting Terminal Value to PV: How & Why?
- Terminal Value = co's PV of its FCFs from end of forecast period onward into infinity, AS OF the final year
- BUT: trying to calculate what the co is worth TODAY
==> If discount rate stays the same each year, use standard PV formula
41
Implied TEV in Unlevered DCF Analysis
= PV of Terminal Value + PV of UFCFs
--> Compare to Co's Current TEV
BUT: for public co's & many private cos --> useful to go a step further => Calculate Implied EqV & Implied Share Price
Why? - 1) All valuation methodologies are about valuing Co's Equity (Debt, Pref Stock, other sources = all easier to value); and 2) If FCF projections include unusual items --> can capture impact w/ Implied Share Price metric
42
How to calculate Implied EqV & Implied Share Price from Implied TEV?
TEV to EqV:
1) Add non-operating assets
2) Subtract Liability & Equity Items that represent investor groups outside common SHs
= EqV
NOTE: Do not double-count items
- If you DEDUCT an expense w/in FCF => ignore corresponding L&E item in bridge
- If you EXCLUDE or ADD BACK an expense w/in FCF => subtract corresponding L&E item in bridge
Implied Share Price = Implied EqV / Diluted Share count
43
DCF: Why sensitize? How to sensitize?
(+) of DCF: easier to examine range of possible outcomes --> Want to look at full range of possibilities in investing
- 2 methods: 1) Scenarios and 2) Sensitivities
Sensitivities = useful when assumptions/drivers don't necessarily correlate w/ each other
==> In most DCF analysis: sensitive Discount Rate vs. Terminal Growth Rate or Terminal Multiples (b/c they both make a huge impact)
44
Walk me through how to use precedent transactions & public comps
1) select universe of (comparable) companies & precedent transactions based on certain criteria & metrics
2) determine relevant financial metrics & multiples for each (ex: EBITDA, revenue) & calculate them for each co & transaction.
3) determine the range of valuation multiples for each set: 25th percentile, median, 75th percentile; low & high
5) apply those multiples to the (corresponding) financial metrics of the co you are currently valuing in order to determine range of the co's implied value(s). do that for all multiples
45
Public Comps - selecting comps & intuition
main criteria:
1. industry
2. geography
3. financial criteria (ex: indicating size size - revenue; ebitda)
*intuition: want to select co's with similar DISCOUNT RATES & CFs.
--> if co's are truly comparable, should have similar discount rates & CFs
- same industry -> subject to same risk factors = should theoretically have similar range of discount rates
-similar financial metrics (ex: revenue) = should theoretically have similar CFs
=> diffs in CF growth rate should explain diffs in the multiples
- look at growth rates of various metrics & corresponding multiples to see how your co is currently price
46
Precedent Transactions - selecting comps
main criteria:
1. industry
2. geography
3. financial criteria (ex: indicating size size - revenue; ebitda)
for precedent transactions: also consider
- TIMING
- financial criteria = based on TRANSACTION VALUE; purchase price at the time deal was announcement (Purchase EqV --> bridge to TEV, rather than EBITDA, revenue, etc)
47
Precedent Transactions - metrics/multiples
- sales-based & profitability-based metrics/multiples
- HISTORICAL metrics/multiples
(ex: LTM Revenue, LTM EBITDA)
*b/c: difficult to find projections for acquired companies at the time they were acquired
48
Public Comps - metrics/multiples
49
DCF - when is it useful vs. not?
useful for:
- mature cos w/ stable, predictible CFs -> future assumptions would be more accurate
not useful for:
- fast-growing, unpredictible co's (ex: in unproven markets), unstable CFs -> future assumptions may not hold up
- co's w/ no profit and/or revenue -> can't predict CFs
- exs: tech start-ups
or
- co's where debt & operating assets & Ls serve v diff roles
(ex: banks; insurance firms)
50
Other valuation methodologies?
- sum of the parts: separate each part of co into diff parts --> value them separately & add them together
- liquidation valuation: BV of assets - BV of Ls => how much eq investors would receive (if co was liquidated)
- M&A premiums: look at premiums paid for the co in past M&A transactions
- LBO analysis: minimum that PE firm could pay to reach a certain level of IRR
- future share price analysis: use P/E multiples of comparable co's to PROJECT out co's future share price & DISCOUNT it back to present value
51
Liquidation Valuation - what is it? when is it useful? when would it produce highest value?
- BV of assets - BV of Ls ==> how much eq investors would get
useful in:
- bankruptcy scenarios - would investors get anything after paying off Ls?
- advising co's re whether it's better to sell off 100% of their co or sell of assets separately
- would produce highest value if: disconnect bt book value & market value
--> co had substantial hard assets that market was undervaluing (ex: b/c of earnings miss; cyclicality)
52
Sum of the Parts Valuation - what is it? when is it useful?
- separate each part of co into diff parts
--> value them separately using diff sets of comps & precedent transactions ==> add them together
useful when:
- co has diff, unrelated divisions
(ex: conglomerate like GE)
53
LBO analysis - what is it? when to use?
- minimum (SET THE FLOOR) that PE firm would pay to reach a certain level of IRR
useful when:
- PE buyer & LBO
- strategic buyers also use when competing w/ financial sponsors for a co -> see what a PE buyer would pay
54
Football Field - applying valuation methodologies
apply valuation methodologies by presenting them all on a "football field":
- for each valuation methodology: calculate the 25th percentile, median, 75th percentile; min & max
- multiply each by corresponding financial metric for this co
--> find range of values produced by each method
for public cos:
- can also use this to work backwards & find implied equity value and implied price p/share
55
EBIT vs. EBITDA - how to calculate? how are they diff?
- conceptually: EBITDA supposed to move closer to a co's "cash flows" by adding back in D&A
(problem: but then does not account for capex at all), whereas EBIT at least indirectly accounts for a co's capex
- to calculate:
EBIT = operating income; includes D&A expenses
(rev - cogs - operating expenses)
EBITDA = EBIT + D&A
(adds D&A back in b/c they are non-cash expenses)
56
DCF analysis process
1. Project co's CFs in explicit forecast period (5-10 years)
2. calculate co's discount rate, usually WACC
3. discount CFs, using WACC + sum up = PV of CFs
4. calculate co's terminal value
5. discount terminal value to current period
6. add PV of FCFs + PV of terminal value
57
DCF - intuition behind why you use FCFs?
- FCF = how much after-tax CF co generates on a RECURRING basis, after you’ve taken into account non-cash charges, changes in Operating Assets and Liabilities, and required Capital Expenditures.
*calculate and use FCF in a DCF b/c that closely corresponds to the actual CF that you, as the investor, would receive each year (RECURRING) if you bought the entire company.
=> trying to replicate CFS, EXCEPT only including RECURRING, PREDICTIBLE items.
- CF from Investing (except CapEx) = excluded
- CF from Financing (except mandatory debt repayments for levered FCF) = excluded
58
Why use FCF in a DCF, rather than another metric like Net Income, EBITDA?
- FCF accounts for capex, unlike EBITDA. => more accurate
- FCF accounts for changes to cash due to changes in working capital => more accurate
(ex: account receivable, accounts payable, inventory)
59
Beta - intuition behind using using comparable companies beta vs. historical beta?
- assumption that co's "true" riskiness = more in-line w/ how risky similar co's in the market are, than to its own historical track record
--> figuring out what a co's beta SHOULD be, rather than what it currently is
60
Multiples Method vs. Gordon Growth Method - which to use?
- (-) both are difficult to determine precisely
- cyclical industry or multiples harder to predict --> gordon growth
- multiples easier to predict --> multiples method
61
Rules of thumb for Cost of Equity:
- Smaller companies generally have a higher Cost of Equity than larger companies because expected returns are higher.
- Companies in emerging and fast-growing geographies and markets also tend to have a higher Cost of Equity for the same reason.
- Additional Debt raises the Cost of Equity because it makes the company riskier for all investors.
- Additional Equity lowers the Cost of Equity because the percentage of Debt in a company’s capital structure decreases.
- Using Historical vs. Calculated Beta doesn’t have a predictable impact – it could go either way depending on the set of comps.
62
Rules of thumb for WACC:
- Assuming that the companies all have identical capital structures, the first two points above about Cost of Equity also apply to WACC – it’s higher for smaller companies and those in emerging markets.
- Additional Debt reduces WACC because Debt is less expensive than Equity.
Yes, Levered Beta will go up, but the additional Debt in the WACC formula more than makes up for the increase.
- Additional Preferred Stock also generally reduces WACC because Preferred Stock tends to be less expensive than Equity (Common Stock).
- Higher Debt Interest Rates will increase WACC because they increase the Cost of Debt.
63
DCF analysis - basic concept?
- value a co based on the PV of its future FCFs
--> "future" = divided in 1) near future period and 2) "far future" period
- near future: est., project + add up FCFs
- far future: harder to est
--> discount everything bc money today is worth more than money tomorrow
64
Revenue to FCFs? - UNLEVERED
Rev to UNLEVERED FCFs:
Revenue
- COGS &Other Operating Expenses
= EBIT
EBIT * (1-Tax Rate)
+ D&A (and other recurring, non-cash add-backs)
+/- change in WC
- CapEx
= Unlevered FCFs
*intuition = include if:
1) recurring and
2) affects all investor groups
*revenue = projected based on assumptions about revenue growth
*project 3 key items that impact FCF:
1) non cash charges (ex: D&A) (increases CF)
2) change in operating As & Ls
3) cap ex
65
Revenue to FCFs? - LEVERED
Revenue to LEVERED FCFs:
Revenue
- COGS & Other Operating Expenses
= EBIT
- NET interest expense (- int expense + int income)
* (1-Tax rate)
+ D&A (and other non-cash expenses)
+/- change in WC
- CapEx
- mandatory debt repayments
*Levered FCF DCF: affected by terms of the DEBT (interest rate and/or repayment schedule) -> diff assumptions will change value from DCF
66
Explicit forecast period (5-10 years) - intuition?
as far as you can reasonably predict for most cos
- less than 5 = too short to be useful
- more than 10 = hard to project
*BUT: sometimes might project than 10 years if it's a CYCLICAL industry (ex: chemicals) b/c impt to show entire cycle (from high to low)
67
Cyclical industry - affect on DCF?
Forecast period:
- might project more than 10 years (to show entire cycle)
68
DCF - what discount rate to use?
- unlevered FCFs = use WACC
- levered FCFs = use Cost of Equity
69
DCF - range of values
- implied value from DCF as a single number itself doesn't mean much; should look at a range of values
--> through diff assumptions about growth rate, revenue growth, margins, etc.
70
Dividend Discount model
- alternative to DCF
COME BACK AND FINISH
71
FCF - why subtract non-cash charges?
- reflect fact that these charges save the co TAXES, but co doesn't actually pay these expenses in cash -> gets you to co's actual CFs
72
Calculating FCF - do you always exclude CFs from Investing (except Capex) and CFs from Financing?
- most of the time, yes, unless you know in advance those items are going to be recurring
73
Why use EBIT, rather than EBITDA, to calculate unlevered FCF?
- b/c accounts for taxes
74
FCF calculation - why account for net change in operating assets & liabilities?
- these changes reflect changes in co's cash flow
- account for cash changes from operationally-linked BS items
-> if operating assets increasing BY more than liabilities -> co is spending cash --> reduces CFs
-> if operating liabilities increase BY more than assets -> co is increasing CFs
75
Negative FCFs - effect on DCF?
- co's value would decrease
- depends on if co ever turns CF positive:
- if yes after a certain point -> DCF could still work
- if no -> DCF will always be negative; maybe look at diff method
76
Assumptions in a DCF?
77
Cost of Equity - how are dividends factored in?
- factored into Beta
- Beta represents how much more you earn on (your returns) investing in this co's individual stock, in excess of the market
- this return includes dividends
78
Cost of Equity calculation - alternative other than CAPM?
= (Dividends per Share / Share Price) + Growth Rate of Dividends
use when:
- co is GUARANTEED to issue dividends
- and/or info on Beta (or other COE factors) are unclear
79
Levered Beta - intuition (for why it is use in COE calculation)
- taking on debt = increases risk for all investors, including equity investors -> increases cost of equity
- levered beta = includes risk from debt/leverage
80
Beta calculations (unlevering/relevering) - how is preferred stock accounted for?
- count preferred stock as equity
- b/c: preferred dividends are NOT tax-deductible, unlike interest paid on debt
81
Beta - can it be negative? EXAMPLE?
- theoretically: beta can be negative. it could mean the asset moves in opposite direction from market as a whole.
(ex: if beta is -1 --> when market goes up by 10%, asset would go down by 10%)
- ex: Gold is an asset with a negative Beta - often performs better than stock market declines & acts as a "hedge" against disastrous events.
- but in practice: rarely, if ever, see negative Betas. even something "counter-cyclical" still follows the market as a whole (might have a beta of 0.5, not -1)
82
Beta - what types of co's would have higher betas?
- co's in "riskier" industries
(ex: tech company beta > manufacturing co beta)
83
(1-Tax Rate)*Debt in WACC formula - if firm is losing money, do you still do this? how can a tax shield exist if a firm is not paying taxes?
- in practice: do this anyways b/c doesn't matter whether debt is CURRENT reducing co's taxes; what matters is whether there's POTENTIAL for that to happen in the future
*cost of debt = represents what return it would yield if co issued ADDITIONAL debt (future)
84
Taking on additional Debt - impact on WACC?
- increases % of debt in capital structure -> decreases WACC b/c cheaper than equity & preferred stock (those %s decreases)
- but also increases cost of equity & cost of preferred stock
debt = cheapest
preferred stock = middle
equity = most expense
85
Financial crisis/econ downturn - impact on WACC?
GO BACK - BIWS 2019 GUIDE q 15 dcf
86
DCF - intuition behind why you need both value from projection period & terminal value
- DCF = co's near future value + far in the future value
- need near future: or else, saying co has NO VALUE in near future but then miraculously have value starting in far future period
87
Precedent Transactions - flaws?
1) no 100% comparable transaction -- affected by transaction structure, co size, market sentiment
2) less data avail (esp for acqs of small, private co's)
88
Reasons for diff EBITDA multiples for diff transactions?
1) PROCESSES can differ:
- one was more competitive / more competitive bidding
2) RECENT NEWS / DEVELOPMENTS:
- co had recent bad news or depressed stock price? --> can acq at discount
3) INDUSTRY: diff industries have diff median multiples
4) FINANCIAL PROFILES can differ
89
LBO vs. DCF - which would give higher valuation?
- could go either way, but LBO typically gives lower valuation
- LBO = valuing based on terminal value only, not CFs bt Y1 and final year; doesn't by itself give you a specific valuation. Rather, set a desired IRR & determine how much you could/would pay for that co.
- DCF = take into account both CFs in between and its terminal value
90
How to value a co w/ no profits, no revenues?
- use comparable companies & precedent transactions & look at more creative multiples (ex: EV/unique vistitors), rather than multiples based on financial metrics (ex: Revenue, EBITDA)
- don't use far in future DCF b/c can't reasonably predict CFs for co that isn't making $ yet
91
Free Cash Flow multiples - use EqV or TEV w/ it?
- Unlevered FCF = use TEV
*excludes interest expense --> represents $ avail to all investors
- Levered FCF = use EqV
*includes interest expense --> $ avail to only eq inv
92
How to APPLY the 3 valuation methodologies to actually get a VALUE for co?
1) take median multiple of a set of co's or transactions (from your methods)
2) multiply median multiple w/ your co's corresponding metric
==> gets you to implied value
3) make "football field": look at min, max, 25th, 75th, median in each set & create range based on each methodology
93
What do you use a valuation for?
- pitch books & client presentations ==> providing updates; tell them what to expect for their own valuation
- fairness opinion: "proves" value client is paying or receiving in a deal is "fair" financially
- defense analyses, merger models, LBO models, DCFs
94
reasons for why would co be valued at a PREMIUM (compared to comparable companies), despite having similar growth/profitability?
- competitive adv/intangible value not captured by financial metrics (ex: IP; key patent)
- litigation: just won favorable ruling
- market leader in industry & greater market share than competitors
- timing: co has just reported earnings well above expectations; stock price recently risen
95
public comps - flaws?
- no 100% comparable company
- stock market movements --> may make multiples v high or low on certain dates
- small co's w/ thinly traded stocks --> share prices may not reflect full value
96
Co's competitive advantage - how to account for it in a valuation?
- instead of looking at median, look at 75th percentile or highly
- add a premium to multiples
- use more aggressive projections
97
Co is at competitive disadvantage, not performing well, is distressed - how to account for it in a valuation?
- look at 25th percentile, rather than median
98
Why would precedent transaction NOT produce higher value than comparable companies?
- mismatch between m&a market and public market
(ex: no public co's recently acquired, but lot of small private co's acquired at v low valuations)
99
EV/EBIT vs. EV/EBITDA vs. P/E multiples - when to use what multiple?
- all measure profitability but:
P/E = depends on cap structure
--> use for co's where int payments/expenses are critical (ex: banks, financial institutions)
EV/EBIT & EV/EBITDA = capital structure neutral
- EV/EBIT = better for industries w. large D&A and capEx/fixed assets is impt (ex: manufacturing)
- EV/EBITDA = industries where fixed assets are less impt, D&A is smaller (ex: internet)
100
Charges reflected in EBITDA - effect on multiple?
*assuming ev is the same for both:
- if charge reflected in EBITDA (ex: SG&A) --> lowers ebitda ==> ev/ebitda multiple higher
- if charge NOT reflected in EBITDA (ex: D&A) --> higher ebitda ==> ev/ebitda multiple lower
101
Private co - valuation?
can use same methodologies as public co w some diffs:
- comparable cos: may apply "discount" bc private co is not as "liquid" as public comps
(*contra precedent transactions: might NOT "discount" b/c - once a co it acquired, shares become illiquid)
- valuation will show tev, rather than implied p/share
- DCF: estimate WACC based on public comps WACC, rather than try to calculate (b/c no market cap or beta)
- CAN'T use: premiums analysis or future share price analysis
102
Can you use private co's in your valuation methodologies?
in precedent transactions only
don't use in:
- public comps - b/c not public co
- dcf wacc/coe calc - b/c not public --> no market cap or beta
103
Revenue to FCF (unlevered)? (in DCF projections)
Revenue
- COGS & other operating expenses
= operating income (aka ebit)
*(1-tax rate)
+ D&A & other non-cash charges, if recurring
+/- change in WC
- Capex
= UNLEVERED FCF
104
Alt way to calculate FCF - unlevered and levered?
Levered =
CFO
- Capex
Unlevered =
CFO
- Capex
+ Int expense (tax-adjusted)
- Int income (tax-adjusted)
105
EBITDA to FCF?
106
FLAWS W/ VALUATION MULTIPLES? (what impacts it)
(Why are valuation multiples and growth rates often not as correlated as you might expected?)
1) diff bt CFs and financial metrics used in valuation multiples
2) hard to find 100% comparable companies --> creates diffs in discount rates
3) current events --> can change co's short term market valuation
107
Why would co's EBITDAx be higher than median comparable companies?
- market expect co's CFs to grow more quickly than comparable companies
(*if similar size co's in same industry --> risk & potential returns should be similar, so DR unlikely to differ by huge amount)
- current events
108
How to decide whether to buy a co, based on its multiple?
- depends on how each co compares to its peers in terms of growth rates & multiples
==> try to find co's that are are UNDERVALUED: similar or lower multiples than peer co's, despite same or similar growth
109
LTM calculation?
Prior Fiscal Year + Current Stub - Previous Stub
110
What's the impact on FCF when days accounts receivable increases?
111
Effect on stock when co issues dividends? When co takes on a bond?
112
Cost of Equity - what does it mean intuitively?
- long-term avg % this co's stock SHOULD return each years
- factors in both: 1) stock-price appreciation and 2) dividends
- in a valuation: represents avg annualized % that equity investors might earn over the long term.
- to a co: COE = cost of funding its operations by issuing additional shares to investors
- co "pays for" Eq via 1) potential Dividends (a real cash expense) and 2) by diluting existing investors
113
WACC FORMULA - INTUTION?
*intuition: stocks are riskier & have higher potential returns than govt bonds --> take the yield on those govt bonds, add the extra returns that you could get on the stock market, then ADJUST for this co's specific risk & potential returns
114
Equity Risk Premium - how to calculate for multinational co in many geographies?
115
Beta formula - intuition for why we multiply debt/equity ratio to (1-tax rate)?
- interest (from debt) is tax-deductible --> reduces the risk of debt
116
DCF - most impt assumptions?
- financial projections (affects projected FCFs)
- WACC (affects everything!)
- Terminal Value
117
Beta for a private company?
- calculate predicted beta based on comparable companies
118
Effect of share buybacks on EPS?
It boosts EPS by reducing the number of commin shares outstanding, each stakeholder how has a larger piece of the pie (net income). (So, if share price remains the same, the P/E ratio will decrease)
119
Why is equity more expensive than debt? What about preferred stock vs. equity & debt?
3 MAIN FACTORS: 1) risk, 2) returns, 3) taxes
- offers higher risk and higher potential returns
- higher returns: expected stock mark returns exceeds YTM on Debt in most cases --> makes Cost of Equity higher. but
- but, interest on debt is also tax-deductible --> reduces cost of debt ==> makes Equity more expensive
- dividends on preferred stock are not tax deductible -> more expensive than debt. higher risk & potential returns than debt, but lower risk/returns than eq. get paid out before eq SHs.
120
Diff WAFF rates in diff years in a DCF?
- if co is growing quickly rn but expected to grow more slowly in the future (--> decrease DR each year until co reaches maturity). makes less sense to do this for mature co's.
121
2 similar size cos in same industry --> one co in a developed market (DM) vs emerging market (EM). Will EM co always have higher wacc?
- certain wacc components (Ex: rf rate, eq risk premium, cost of debt) = higher for em co
- if levered beta is similar or higher for em and cap structure %s are similar, then wacc should be higher as well
- there are cases where diffs in the cap structure or strange results for levered beta might result in similar or lower wacc for the em co
- ex: if govt heavily controls industry in the em --> levered beta might be lower for the em co due to reduced volatility
122
Diffs bt explicit forecast period and terminal period?
- in explicit forecast period: co's FCF growth rate (and possibly discount rate) changes over time --> co is still growing/changing
-terminal period: assume co remains in a "steady state" forever --> FCF grows at same rate each year & DR stays the same
123
Terminal growth rate increase - impact on dcf value?
increases
124
Impact of Tax Rate on DCF: Cost of Equity, Cost of Debt, WACC, Implied Value
Tax Rate only impacts value in a DCF if the company has DEBT. If the co has NO debt, or its targeted/optimal capital structure does not include debt, the tax rate doesn't matter b/c no tax benefit from debt.
If co DOES have some debt: HIGHER tax rate REDUCES cost of equity, cost of debt, WACC, and REDUCES FCF & Terminal Value.
Cost of Debt: Since you multiple Cost of Debt by *(1-Tax Rate) (tax shield) --> higher tax-rate reduces after-tax cost.
Cost of Equity: also reduced. With greater tax benefit, Debt is even less risky to Equity investors (--> in the Levered Beta calculation, accounts for this by multiplying debt/equity ratio by the tax rate).
--> WACC: If both COE/COD is lower, WACC will be lower.
FCF & Terminal Value: Higher tax rates reduces FCF & the Terminal Value
==> In sum: lower WACC (reduces TEV) and higher FCF & Terminal Value (increases TEV).
- So depends. If overall TEV is lower/higher.
If tax rate lowers, the opposite is true.
125
How to value a Co w/ no revenue? (*Q)
- Prob not best to use a DCF
- use public comps
126
Can you walk me through the process of finding the market and financial information for the Public Comps?
1) Find each co's most recent annual/interim flings. Calculate its diluted share count and Current EqV & Current TEV based on info in there & its most recent BS.
2) Calculate its LTM financial metrics: take most recent annual results, add results from most recent partial period, and subtract results from same partial period the last year.
3) For projected figures: look in eq research or find consensus figures on Bloomberg, Cap IQ, Yahoo etc. Calculate all the multiples by dividing Current EqV & Current TEV by the appropriate metric.
127
How do you decide which metrics and multiples to use in these methodologies?
- usually look at a sales-based metric and its corresponding multiple and 1-2 profitability-based metrics and their multiples.
ex: you might use Revenue, EBITDA, and Net Income, and the corresponding multiples: TEV / Revenue, TEV / EBITDA, and P / E.
*Intuition: you want to value a company in relation to how much it sells and how much it keeps of those sales. Sometimes, you’ll drop the sales-based multiples and focus on the profitability or cash flow-based ones (EBIT, EBITDA, Net Income, Free Cash Flow, etc.).
128
Why do you look at BOTH historical and projected metrics and multiples in these methodologies?
Historical metrics:
(+) useful b/c based on what happened IRL
(-) can be deceptive if there were non-recurring items or if the co made acquisitions or divestitures
Projected metrics:
(+) useful b/c assume the co will operate in a "steady state" - w/out acqs, divestitutres, or non-recurring items
(-) less reliable b/c based on future predictions
129
How do you interpret the Public Comps? What does it mean if the median multiples are above or below the ones of the company you’re valuing?
The interpretation depends on how the growth rates and margins of your company compare to those of the comparable companies.
Public Comps are most meaningful when the growth rates and margins are similar, but the multiples are different. This could mean that the company you’re valuing is mispriced and that there’s an opportunity to invest and make money.
For example, maybe all the companies are growing their revenues at 10-15% and their EBITDA at 15-20%, and they all have EBITDA margins of 10-15%. Your company also has growth rates and margins in these ranges.
However, your company trades at TEV / EBITDA multiples of 6x to 8x, while the comparable companies all trade at multiples of 10x to 12x.
This result could indicate that your company is undervalued since its multiples are lower, but its growth rates, margins, industry, and size are comparable.
If the growth rates and margins are very different, it’s harder to draw conclusions.
130
How do you factor in earn-outs and expected synergies in Precedent Transactions?
You generally don’t factor in expected synergies because they’re quite speculative.
If you do include them, you might increase the sellers’ projected revenue or EBITDA figures so that the valuation multiples end up being lower – assuming that you’re using projected metrics.
Opinions differ about earn-outs, but you could assume they have a 50% chance of being paid out, multiply the earn-out amounts by 50%, and add them to the purchase prices. Other people ignore earn-outs or add the full earn-out amounts to the Purchase Equity Value and Purchase Enterprise Value.
131
Would it ever make sense to use a negative Terminal FCF Growth Rate?
Yes. For example, if you’re valuing a biotech or pharmaceutical company and the patent on its key drug expires within the explicit forecast period, it might be reasonable to assume that the company never replaces the lost revenue from this drug, which results in declining cash flow.
A negative Terminal FCF Growth Rate represents your expectation that the company will stop generating cash flow eventually (even if it happens decades into the future). It doesn’t make the company “worthless”; the company is just worth less.
132
How can you check whether or not your Terminal Value estimate is reasonable?
133
Why do we use the mid-year convention in a DCF?
Use it to represent that a co's CFs does not come 100% at the end of each year. Instead, it comes in evenly throughout each year
- In a DCF WITHOUT mid-year convention, we would use discount period #s of 1 for the first year, 2 for the second year, 3 for the third year, and so on
- In a DCF WITH mid-year convention: would instead use 0.5 for the 1st year, 1.5 for the 2nd year, 2.5 for the third year etc.
134
What discount period numbers would I use for the mid-year convention if I have a stub period in my DCF?
- divide stub discount period by 2, and then subtract 0.5 from the "normal" discount periods for the future years
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