Valuation

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The Investment Banking Institute
 Table of Contents

I. Valuation Overview

II. Comparable Public Companies

III. Precedent Transactions

V. Discounted Cash Flow (DCF) Analysis

VI. Conclusions

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 What Is Valuation?
ƒ How much is Computer Retailer Company A worth? (i.e. what is its
valuation?)
ƒ Company A will have different values to different buyers
ƒ Would the following buyers be willing to pay more or less for a piece
of the Company’s equity?
¾ An individual or fund looking to buy stock in the public market and be a
minority shareholder (i.e. does not have much influence on the company’s
management, operations, strategy, etc., other than the occasional
shareholder vote)
¾ A competitor looking to acquire 100% of the company and merge it into its
own company, with the intention of attaining synergies such as price
increases to customers, operational efficiencies, savings from shutting
down one corporate headquarters and firing redundant employees, etc.
¾ A private equity firm that wants to buy 100% of the company for its own
investment portfolio, and therefore have strong influence and control
over the company’s management team, strategy, operations, etc.

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 What Is Valuation? (cont.)
ƒ If Company A is listed on a stock exchange and its equity shares are publicly
traded, then you can derive its valuation (i.e. how much it is worth) based
upon the share price and other publicly available information such as SEC
filings, research reports and press releases
¾ This is the “Public Market Valuation”
ƒ The “Public Market Valuation” provides one perspective on the Company’s
valuation: it illustrates at what price minority shareholders are willing to buy
and sell the equity shares of that company
ƒ In addition to the Public Market Valuation, there are three methodologies
commonly used to derive a company’s valuation, providing three different
valuation perspectives:
¾ (1) Comparable Public Companies (aka Trading Multiples)
¾ (2) Precedent Transactions (aka Acquisition Multiples)
¾ (3) Discounted Cash Flows (“DCF”)
ƒ These three methodologies allow for the valuation of both publicly traded
companies and privately held companies, provided you have some or all of the
following information for the company that you want to value:
¾ Recent income statement information (Revenues, EBIT, EBITDA, Net Income, etc.)
for the company that you want to value
¾ Recent balance sheet information (cash balance, debt balance, minority interest
balance, preferred and common equity information, number of equity shares
outstanding, etc.)
¾ Projected income statement information (for next 1 – 2 years)

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 What Is Valuation? (cont.)

ƒ Every transaction requires an understanding and agreement of

a company’s fair market value (FMV)
¾ What is FMV?
– Price at which an interested, but not desperate, buyer is willing to
pay and an interested, but not desperate, seller is willing to accept on
the open market
– How is this different from book value?
¾ What is market value of equity (MVE)?
– MVE or market cap = price per share x total shares outstanding
– MVE vs. stockholder’s equity on the balance sheet
ƒ MVE ≠ aggregate value
¾ MVE represents only the value from stockholders
¾ What about the value contributed by other stakeholders?
¾ Aggregate or total enterprise value (TEV) is the value attributed
to ALL providers of capital

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 Total Enterprise Value (TEV)
ƒ Company valuations are performed for the purpose of
determining the value of the operations
¾ Does not focus on value to specific stakeholders (e.g. MVE)
¾ Ignores leverage
¾ Think of real estate to differentiate between TEV and MVE:
– House value = TEV; home equity = MVE; mortgage = debt
ƒ TEV = MVE + debt + preferred stock + minority interest – cash
¾ Share Price = $50.00
¾ Shares Outstanding = 200 million
¾ Preferred Stock = $0
¾ Debt = $2,000 million
¾ Minority Interest = $0
¾ Cash = $500 million
¾ TEV = ?

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 Total Enterprise Value (TEV) (cont.)
ƒ Remember, common stock, preferred stock, debt and minority
interest are ALL providers of capital (right-side of the balance
sheet)
ƒ What is minority interest and why is it included in TEV?
¾ If you own more than 50% but less than 100% of another entity,
you are required to consolidate its financials on to your company
financials. Minority interest represents the portion of equity that
your company does not own – it is a liability
¾ Therefore, in a TEV / Revenue calculation, if your denominator
represents a fully consolidated operating figure, it is necessary to
gross up your numerator (TEV) to keep the equation balanced or
“apples to apples”
¾ In a leveraged multiple such as P/E, this adjustment is not a
concern because the earnings calculation is net of minority
interest (i.e. minority interest expense has already been taken
out)

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 Total Enterprise Value (TEV) (cont.)
ƒ Why do we subtract cash in the TEV calculation?
¾ Common misconception: cash is netted against debt
¾ Cash sitting on the books is not a contribution of value to the
enterprise or operations
– However, cash is a contribution to MVE (i.e. value to stockholders)
– Therefore, because cash is in MVE, which is a component of TEV, we
need to subtract cash
¾ To further understand the exclusion of cash, think of two (2)
runners of equal ability
– Runner 1 has $5.00 in his pocket
– Runner 2 has $100.00 in his pocket
– Is Runner 2 necessarily a better or more valuable runner than
Runner 1?

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The Investment Banking Institute
 Table of Contents

I. Valuation Overview

II. Comparable Public Companies

III. Precedent Transactions

V. Discounted Cash Flow (DCF) Analysis

VI. Conclusions

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 Comparable Public Companies
ƒ You can value a company based on how similar companies
trade in the public markets
ƒ The first step is to pick the comp universe (size depends on
relevance)
¾ The goal is to find companies of similar:
– Industries
– Business Models
– Profitability
– Size
– Growth
– Geography (International vs. Domestic)
¾ Sources include:
– Equity research reports
– “Competitors” section from 10-K
– SIC codes
– Internet
– Senior bankers
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 Multiples Analysis
ƒ Relative valuation is a method based on applying multiples
¾ A valuation multiple is a ratio between a value and an operating
metric (financial institutions may look at balance sheet metrics)
– For example: P/E ratio; price = value, earnings = operating metric
– Therefore, with a given multiple and a variable, you can determine
the missing variable
– P/E = 25.5x, Earnings = $30 million; MVE = ?
ƒ There are two (2) types of trading multiples
¾ Operating (debt-free)
¾ Equity
ƒ Operating (debt-free) multiples
¾ TEV / Revenue, EBIT or EBITDA
¾ TEV = $11,500M; Revenue = $19,426M; EBITDA = $1,369M
¾ Revenue Multiple = 0.59x
¾ EBITDA Multiple = 8.4x

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 Operating Multiples
ƒ Why is TEV a part of operating multiples and not MVE?
¾ “Apples to Apples”
¾ Remember, TEV ignores specific capital contribution
¾ Line items before interest are considered debt-free
¾ MVE is value to only stockholders and is affected by leverage
ƒ Let’s say our subject company, a widget maker, has annual
financials of the following:
¾ Revenue: $19,426 million
¾ EBITDA: $1,369 million
ƒ Mean trading multiples for publicly-traded widget companies
¾ TEV / Rev: 0.74x
¾ TEV / EBITDA: 10.3x

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 Operating Multiples (cont.)
ƒ What’s is our company’s implied TEV?
¾ Revenue: $19,426 million
¾ EBITDA: $1,369 million
¾ Implied TEV using revenue multiple = $19,426 million * 0.74x =
$14,375 million
¾ Implied TEV using EBITDA multiple = $1,369 million * 10.3x =
$14,101 million
¾ Average Implied TEV = average ($14,375 million, $14,101
million) = $14,238

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 Equity Multiples
ƒ Unlike operating multiples, equity multiples are a function of
MVE
ƒ Since the general public owns common stock and not other
types of securities, analysts speak in P/E ratios
¾ Price per Share / Earnings per Share
¾ Market Cap / Earnings
ƒ Again P/E is a function of MVE, which is not a good indicator of
company valuation
ƒ Equity multiples require the denominator to be below the
interest line (i.e. net income)
¾ Again, “Apples to Apples”
¾ Wrong: TEV / Earnings
¾ Wrong: Market Cap / EBITDA

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 “Spreading” Comps
ƒ Spreading comparable public companies and precedent
transactions require an “apples to apples” comparison
¾ Same time frame – Last Twelve Months (“LTM”), Fiscal Year End
(“FYE”) or latest quarter annualized (“LQA”)
– Always use most recent financials
– Companies have different fiscal year-ends
¾ Normalizing numbers – adjusting EBIT, EBITDA and net income
– Normal operating status
– Back-out non-recurring items (operating vs. non-operating)
– Include certain recurring items (operating vs. non-operating)
– Continued vs. discontinued operations
ƒ Forward-looking numbers are very important
¾ Many growth industries (e.g. technology) only look at FYE+1 or +2
¾ Historical performance is not an indicator of future performance
¾ Projections are sourced from management and equity/high
yield/credit research reports

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 “Spreading Comps” (cont.)
ƒ Calculating TEV
¾ All components need to be at fair market value
– MVE = current share price x fully diluted shares outstanding*
– FMV of preferred stock = public market price or liquidation preference
(notes)
– FMV of debt = generally face value unless distressed (balance sheet)
– FMV of minority interest = what is stated on balance sheet
– FMV of cash = what is stated on balance sheet

*discussed on following pages

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 “Spreading Comps” (cont.)
ƒ Calculating Fully-Diluted Shares
¾ Basic vs. fully-diluted (FD) shares outstanding
– Dilution is built into the stock price
9 if dilutive securities are “in-the-money”, the market assumes that the
securities are already converted to common stock
9 A convertible security or option is “in-the-money” if the current share price
is greater than the strike price
– Dilutive securities include:
9 Options
9 Warrants
9 Convertible preferred stock or debt (do not double-count if already
converted)
¾ Market Capitalization and TEV should always be calculated using
fully-diluted shares
– Using basic shares outstanding will undercut the valuation, sometimes
significantly
– In certain industries where options are a large part of employee
compensation and incentive, the amount of dilutive shares can be
sizeable

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 “Spreading Comps” (cont.)
ƒ There are two (2) generally accepted methods for calculating
dilutive shares
1. Weighted-average dilutive shares assumed by management
2. The Treasury Stock Method (TSM)
1. Weighted-average dilutive shares
¾ Looks at the weighted-average number of new shares created
from unexercised in-the-money warrants and options over a
period of time
– Commonly used in the calculation of diluted EPS
– Applies greater weight to those periods of higher earnings
– Does not provide an accurate spot account of the total number of in-
the-money securities
¾ Located in the EPS note of the notes section
– Most recent account of dilutive data (available in the 10Q and 10K)
– Lack of transparency or support - based on management discretion
– Ignores the effect of proceeds received from exercising dilutive
securities
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 “Spreading Comps” (cont.)
2. The Treasury Stock Method (TSM)
¾ The net of new shares potentially created by unexercised in-the-
money warrants and options
¾ This method assumes that the proceeds that a company receives
from an in-the-money option exercise are used to repurchase
common shares in the market
¾ TSM = Exercisable Options Outstanding x (Share Price - Strike
Price) / Share Price
– Exercisable Options Outstanding is only found in the Options Table in
the notes section of the 10K
9 Full-year lag between a new set of updated options information
– Exercisable Options Outstanding represents the portion of Total
Options Outstanding which is vested or earned
9 Note: Total Options Outstanding is used in the TSM for Precedent
Transactions due to change of control provisions (to be explained in the
next section)

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 “Spreading Comps” (cont.)
2. The Treasury Stock Method (TSM) (cont.)
¾ TSM does not account for in-the-money convertible preferred or
convertible debt
– This must be calculated separately by figuring out the conversion
prices or conversion ratios of each of the convertible securities
9 Conversion prices or conversion ratios are always detailed in the bond
indenture or birth document of a convertible security and oftentimes in a
10K
– If convertible securities are in-the-money, they are converted in
equity as a form of dilutive securities
– In the calculation of TEV, be careful not to double count pre-
converted and post-converted values of the same security
9 The conversion of a convertible security into equity means that its pre-
converted form can no longer exist
9 For example, if you convert $500 million of convertible debt into dilutive
shares, you must remember to remove $500 million from total debt

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 “Spreading” Comps (cont.)
ƒ Best Buy Co. Comp Spread Example

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 Selecting Multiples and Ranges
ƒ Selecting multiples for implied valuation
¾ Eliminate outliers
¾ Average (mean) vs. median
¾ Total versus stripped averages
¾ Upper and lower quartiles
ƒ Risk Rankings
¾ Emphasis towards companies with closer business models, size,
growth and profitability, etc.
ƒ Identifying meaningful implied valuation ranges
¾ Not too narrow, not too broad
¾ Be consistent
ƒ Public vs. private value
¾ Liquidity discount
¾ Research coverage

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 Table of Contents

I. Valuation Overview

II. Comparable Public Companies

III. Precedent Transactions

V. Discounted Cash Flow (DCF) Analysis

VI. Conclusions

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 Precedent Transactions
ƒ Another form of relative value is precedent transactions
¾ Many argue the most accurate way of determining valuation is
observing what has been recently paid for comparable businesses
in the same space
– Rather than looking to the public markets for comparable company
valuations, you look at valuations based on acquisitions
¾ Again, this is a multiples-based valuation (operating and equity
multiples)
– Multiples which are derived from these transactions are applied to a
company’s operating statistics to determine valuation
¾ Precedent transactions yield an acquisition or control premium
(approx: 20-25% depending on the industry)
– Remember to adjust for minority interest-based valuations
ƒ Selecting comparable transactions
¾ Target company characteristics
¾ Transaction parameters
¾ Time frame
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 Precedent Transactions (cont.)
ƒ Data sources:
¾ SDC or other M&A databases
¾ SEC filings
¾ Equity research reports
¾ Press releases (company or third-party)
¾ Industry news
ƒ Typical information
¾ Announce date vs. transaction date
– The price at which a transaction closes at can sometimes be
materially different from the original price offered at announce date
– The spread can be associated to:
9 Change in target or acquirer stock price
9 Transaction-related adjustments
– Considerations should be independent of unforeseen price fluctuations
and transaction-specific costs
¾ Target and acquirer descriptions

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 Precedent Transactions (cont.)
ƒ Typical information (cont.)
¾ Transaction rationale
– What are the business decisions for this acquisition
9 Product expansion, cost synergies, technology integration, etc.
– What are the financial decisions for this acquisition
9 Under-valued stock, poor capitalization, turn-around candidate, etc.
¾ What is the consideration and structure
– 100% cash
– 100% acquirer’s stock
9 Exchange Ratio: The number of shares of the acquiring company that a
shareholder will receive for one share of the target company.
– Combination of cash and stock
9 Each share of target company will receive $12.65 in cash and 1.45 shares of
acquiring company
9 What is the consideration if there are 24 million target shares outstanding
and the acquiring company’s stock price is worth $6.55 at announce date?
– Earn-out provisions
9 Portion of the consideration withheld until operational milestones are
achieved
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 Precedent Transactions (cont.)
ƒ Typical information (cont.)
¾ Implied TEV and MVE
¾ Selected financial and operating information
¾ Implied valuation multiples
¾ Market premiums
– Purchase price divided by the (i) 1-day, (ii) 5-day and (iii) 30-day
average stock price prior to announce date

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 Table of Contents

I. Valuation Overview

II. Comparable Public Companies

III. Precedent Transactions

V. Discounted Cash Flow (DCF) Analysis

VI. Conclusions

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 Discounted Cash Flow Overview
ƒ The DCF calculation represents a company’s “intrinsic” value
¾ Takes all cash flows projected into the future (infinitely) and
discounts it back to present value

Forecasting Free Estimate Cost of Estimating Calculating

Cash Flows Capital Terminal Value Results
• Identify • Perform a • Determine • Bring all cash
components of WACC analysis whether to use flows to present
FCF • Develop target cash flow value
• Keep in mind capital multiple (i.e., • Perform
historical figures structure EBITDA sensitivity
• Project • Estimate cost of multiple) or analysis
financials using equity growth rate • Interpret results
assumptions method (i.e.,
Gordon Growth
• Decide # of years Method)
to forecast
• Discount it back
to present value

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 Pros and Cons of Discounted Cash Flow
ƒ DCF is more flexible than other valuation methodologies.
However, it is very sensitive to the estimated cash flows,
discount rate and terminal value

PROS CONS
•Objective framework for •Very sensitive to cash
assessing cash flows and flows
risk •Unbalanced valuation
•Not dependent upon weight to terminal value
publicly available •Cost of capital depends
information on beta and market risk
premium

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 Discounted Cash Flow (DCF) Analysis
ƒ Free cash flow (FCF) represents cash flow to ALL stakeholders,
hence it is a depiction of TEV
¾ Unlevered value of the firm that is independent of its capital
structure or also known as “debt free”
¾ FCF = EBIT
less: Taxes
Increase/(decrease) in working capital (WC)
Capital expenditures (CapEx)
plus: Depreciation and Amortization
¾ Notice the “before interest” designation in EBIT
¾ Value of Equity = TEV from Operations – Net Debt

ƒ A DCF typically projects five (5) years of FCF plus a terminal

value but it can be longer or shorter

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 Terminal Value
ƒ The terminal value represents the value of an investment at
the end of a period, taking into account a specified rate of
interest (perpetuity)
¾ In other words, it looks at a company’s cashflow projected
infinitely into the future at a particular growth rate
¾ There are two (2) generally accepted methods for calculating the
terminal value
1. Gordon Growth Model
2. Terminal Multiple

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 Terminal Value (cont.)
ƒ Wall street utilizes the terminal multiple
¾ Applying a debt-free multiple (typically TEV / EBITDA) to the ending
year’s operating statistic
¾ Apply the LTM multiple if using the cash flow multiple method
– Terminal Value = (LTM Multiple from Comps) x (EBITDA)
¾ Certain industries may require the use of Revenue, EBIT or Net
Income multiple

ƒ The Gordon Growth Model is exactly what the definition of

terminal value states
¾ It is a constant rate projected forward - a perpetuity
¾ Terminal Value = (Ending Cashflow x (1 + Growth Rate)) / (Discount
Rate - Growth Rate)
¾ Good “sanity check” when backed into Terminal Multiple approach

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 Cost of Capital
ƒ Future cash flows need to be discounted at an appropriate rate
in order to calculate present value
¾ PV = FCF / (1 + discount rate)^year
¾ DCF = PVFCF(1) + … + PVFCF(5) + PV Terminal Value
ƒ Cost of capital (aka, discount rate) is an investor’s required
rate of return or opportunity cost for investing in a particular
risk profile
¾ That is to say, “what return would I require in another investment
of similar risk?”
¾ Higher risk = higher required return
ƒ The cost of capital should match the cash flows to be
discounted
¾ Leveraged cash flows vs. debt-free cash flows
ƒ Common sense is the most important factor in determining the
appropriate cost of capital

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 Cost of Capital (cont.)
ƒ The discount rate is expressed in two (2) basic forms:
¾ (1) Cost of equity
¾ (2) Cost of debt
¾ Cost of preferred stock is included as a hybrid between the two
ƒ Due to the combination of these two (2) types of capital on a
company’s balance sheet, the discount rate is usually referred
to as the weighted average cost of capital (WACC)

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 Weighted Average Cost of Capital (WACC)
ƒ The WACC represents the required rate of return for the
overall enterprise
¾ It is simply a weighted average of the required rates of return for
each of the different sources of capital (equity and debt)
¾ WACC = [Ke x (E/(E+D)] + [(Kd x (D/(E+D)) x (1-T)]
– Ke = cost of equity
– Kd = cost of debt
– E = MVE of subject company
– D = FMV of debt (same as face value unless distressed) of subject
company
– T = tax rate
ƒ Company-specific risk
¾ Size risk
¾ Key-man risk
¾ Business model or projection risk

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 Cost of Equity
ƒ The cost of equity is calculated using the capital asset pricing
model (CAPM)
ƒ CAPM = Rf + Beta x (RM – Rf)
¾ Rf = risk-free rate (10, 20 or 30 year treasury notes)
¾ RM = market rate (Expected return on the market portfolio)
¾ RM – Rf = market risk premium (return above the risk-free rate)
– Calculated by taking an average of data points over many years in
order to incorporate a large sample of events
– Most banks get this rate from Ibbotson Associates (source for risk
premium)

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 Cost of Equity (cont.)
ƒ Beta is the measure of volatility, or systematic risk, of a
security compared to the market as a whole (e.g. S&P 500)
¾ Beta of 1 signals that 1% rise in the market translates into 1% rise
in the stock
¾ Beta of -1 signals that 1% rise in the market translates into 1%
decline in the stock

ƒ Betas outside of a range of 0.5 to 2.5 should be reviewed for

reasonableness

ƒ Firms use 2 year betas to 5 year betas

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 Cost of Equity (cont.)
ƒ Levering and un-levering beta
¾ Beta is a function of risk affected by leverage
¾ In order to make an “apples to apples” comparison among
company returns, leverage needs to be removed from beta
¾ The un-levered beta (mean) should be re-levered with the subject
company’s capital structure (i.e. debt to equity ratio)
– BL = Bu x [1 + D/E x (1-T)]
– Bu = BL / [1 + D/E x (1-T)]
9 BL = Levered Beta
9 Bu = Unlevered Beta
9 T = Tax Rate
9 D = Market Value of Debt
9 E = Market Value of Equity

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 Cost of Debt
ƒ Similar to the cost of equity, the cost of debt represents the
return a lender would require in a security of similar risk
¾ All things being equal, the cost of debt is lower than the cost of
equity for the following two (2) reasons:
– (1) Senior to equity Æ less risk and therefore less required return
– (2) Interest is paid out before taxes
¾ Under certain situations where a company is over-levered, raising
debt may be more expensive due to default risk
ƒ There are two main categories of debt which may be valued
separately
¾ Non-convertible debt (includes capital leases)
¾ Convertible debt, which can be treated as equity if the
convertible is in-the-money and as debt if it is out-of-the-money

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 Cost of Debt (cont.)
ƒ A company’s overall cost of debt is calculated by averaging
(weighted) the coupon rates of its various pieces of debt and
multiplying it by the tax shield (1 - tax rate)
¾ $500M of 8.25% senior notes due 2010
¾ $250M of 9.00% senior notes due 2012
¾ $300M of 12.5% senior subordinated notes due 2012
¾ Tax rate of 40%
¾ Cost of debt = 9.64% x (1-.40) = 5.79%

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 Homework
ƒ Best Buy Co., WACC example
ƒ Best Buy Co., DCF example

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 Table of Contents

I. Valuation Overview

II. Comparable Public Companies

III. Precedent Transactions

V. Discounted Cash Flow (DCF) Analysis

VI. Conclusions

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 Conclusions

Pros Cons
ƒ Highly efficient ƒ Size discrepancy
market ƒ Liquidity difference
Comparable ƒ Easy to find ƒ Hard to find “good”
Public Companies information (public comps in niche market
access)

ƒ Arguably, the most ƒ Poor disclosure on

accurate method private and small
Precedent deals
Transactions ƒ Hard to find “good”
comps in niche or slow
M&A market
ƒ Represents intrinsic ƒ Highly sensitive to
value discount rate and
Discounted terminal multiple
Cash Flow (DCF) ƒ “Hockey Stick”
tendencies –
projection risk

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