Valuation Methodologies

Question 1

Public companies already have Market Caps and Share Prices. Why do you need to “value them” at all? You already know how much they’re worth.

Answer 1

Because a company’s Market Cap and Share Price reflect its Current Value according to “the market as a whole” – but the market might be wrong!
You value companies to see if the market’s views are correct and whether a company’s value might change based on your views.
It’s like going home shopping, finding a house with a list price of $500K, but then negotiating a lower price because you believe it is worth only $450K based on your research.

Question 2

What are the advantages and disadvantages of the 3 main valuation methodologies?

Answer 2

Public Comps are useful because they’re based on real market data, are quick to calculate and explain, and do not depend on far-in-the-future assumptions.
However, there may not be truly comparable companies, the analysis will be less accurate for volatile or thinly traded companies, and it may undervalue companies’ long-term potential.
Precedent Transactions are useful because they’re based on the real prices that companies have paid for other companies, and they may better reflect industry trends than Public Comps.
However, the data is often spotty and misleading, there may not be truly comparable transactions, and specific deal terms and market conditions might distort the multiples.
DCF Analysis is the most “correct” methodology according to finance theory, it’s less subject to market fluctuations, and it better reflects company-specific factors and long-term trends.
However, it’s also very dependent on far-in-the-future assumptions, and there’s disagreement over the proper calculations for key figures like the Cost of Equity and WACC.

Question 3

Which of the 3 main methodologies will produce the highest Implied Values?

Answer 3

This is a trick question because almost any methodology could produce the highest Implied Values depending on the industry, time period, and assumptions.
That said, Precedent Transactions often produce higher Implied Values than Public Comps because of the control premium – the extra amount that buyers must pay to acquire sellers.
But it’s tough to say how a DCF compares because it’s far more dependent on the long-term assumptions used.
The safest answer is: “A DCF tends to produce the most variable output since it’s so dependent on your assumptions, and Precedent Transactions tend to produce higher values than the Public Comps because of the control premium.”

Question 4

Which one should be worth more: A $500 million EBITDA healthcare company or a $500 million EBITDA industrials company?
Assume the growth rates and margins are the same.

Answer 4

In all likelihood, the healthcare company will be worth more because healthcare is a less asset intensive industry. That means the company’s CapEx and Working Capital requirements will be lower, and its cash flow will be higher.
Healthcare, at least in some sectors, also tends to be more of a “growth industry” than industrials.
The Discount Rate might also be higher for the healthcare company, but the lower asset intensity and higher expected growth rates could offset that.
This answer is an extreme generalization, so you would need more information to give a detailed answer

Question 5

Can you walk me through how you use Public Comps and Precedent Transactions in a valuation?

Answer 5

First, you select the companies and transactions based on industry, size, and geography (and time for the transactions).
Then, you determine the appropriate metrics and multiples for each set – for example, revenue, revenue growth, EBITDA, EBITDA margins, and revenue and EBITDA multiples – and calculate them for all the companies and transactions.
Next, you calculate the minimum, 25th percentile, median, 75th percentile, and maximum for each valuation multiple in the set.
Finally, you apply these numbers to the financial metrics of the company you’re analyzing to estimate its Implied Value.
For example, if the company you’re valuing has $100 million in LTM EBITDA, and the median LTM TEV / EBITDA multiple in a set of comparable companies is 7x, then the company’s implied Enterprise Value is $700 million.
You then calculate its Implied Value for all the other multiples to get a range of possible values.

Question 6

Can you give a few examples of how you might screen for “similar” Comparable Public Companies and Precedent Transactions?

Answer 6

You screen based on geography, industry, and size (and time for Precedent Transactions).
Here are a few example screens:
* Comparable Company Screen: U.S.-based steel manufacturing companies with over $500 million in revenue.
* Comparable Company Screen: European legacy airlines with over €1 billion in EBITDA.
* Precedent Transaction Screen: Latin American M&A transactions over the past 3 years involving consumer/retail sellers with over $1 billion USD in revenue.
* Precedent Transaction Screen: Australian M&A transactions over the past 2 years involving infrastructure sellers with over $200 million AUD in revenue

Question 7

How do you decide which metrics and multiples to use in these methodologies?

Answer 7

You usually look at a sales-based metric and its corresponding multiple and 1-2 profitability based metrics and their multiples. For example, you might use Revenue, EBITDA, and Net Income and their corresponding multiples: TEV / Revenue, TEV / EBITDA, and P / E.
You do this because you want to value a company in relation to how much it sells and how much it keeps from 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.).

Question 8

Why do you look at BOTH historical and projected metrics in these methodologies?

Answer 8

Historical metrics are useful because they’re based on what happened in real life, but they can also be deceptive if there were non-recurring items or if the company made acquisitions or divestitures.
Projected metrics are useful because they assume the company will operate in a “steady state” without acquisitions, divestitures, or non-recurring items, but they’re also less reliable because they’re based on predictions rather than historical events.

Question 9

When calculating the forward multiples for the comparable companies, should you use each company’s Current Equity Value or Current Enterprise Value, or should you project them to get the Year 1 or Year 2 values?

Answer 9

You always use the Current Equity Value or Current Enterprise Value. NEVER “project” either one.
A company’s share price, and, therefore, both Current Equity Value and Current Enterprise Value, reflects past performance and future expectations.
So, to “project” these metrics, you’d have to jump into the future and see what future expectations are at that point in time and then time travel back to the present.

Question 10

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?