5/1/23, 10:07 AM Valuation: A Conceptual Overview | Street Of Walls

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VALUATION: A CONCEPTUAL OVERVIEW

of Investment Banking Technical Training

In this chapter we will introduce the reader to some key, high-level concepts required to understand

valuation and how it’s done on Wall Street. We will cover three key topics:

Enterprise Value: The 30,000-Foot View

Understanding Enterprise Value vs. Market Value

An Introduction to Valuation Techniques

Enterprise Value: The 30,000-Foot View

Investment bankers use four primary valuation techniques when advising corporate clients. These

techniques apply almost universally, regardless of the company, industry or circumstance. They will be

introduced in the next chapter, Valuation Techniques Overview.

But how are the valuation techniques actually constructed? When should which technique be used?

What are the basic building blocks required for them? We will find more detailed answers to some of

these questions in the next chapter. However first we’re going to take a step back and explain some of
the building blocks of these valuation techniques so that they make sense when we later discuss them in
technical depth.

In this chapter, therefore, you will find a detailed overview of the core building blocks of the valuation

techniques used by investment bankers.

Enterprise Value (frequently referred to as EV—not to be confused with Equity Value, which is

another name for Market Value of a company) is the core building block used in financial modeling.
The reason is this: Enterprise Value is designed to represent the entire value of the company’s

operations. By contrast, Market Value is a residual: it represents the value of the company remaining

once the value ascribed to other stakeholders (non-owners) has been taken out.

Enterprise Value must therefore account for all of the differences between Market Value (remember,

this figure is the Market Value of a company’s Equity or ownership) and the Value of Operations (or

Operating Value) of a Company.

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Let’s start with a basic identity equation:

Enterprise Value =

Operating Value of a Company =

Net Value of all the Claims on the Company’s Assets (Excluding Excess Cash)

This equation is simple enough. Assuming that the company is profitable, and that it’s more valuable in

operation than in liquidation (in other words, the company is worth more money if it continues in

business rather than stopping business and selling off the assets to the highest bidders), the value of the

company is equal to the value of its productive operations. This value must also equal the value of all of

the net claims against the company’s assets, because these assets are being used to produce money for

these claimants, or stakeholders (assuming, of course, that these claims have been valued correctly).

The “Excluding Excess Cash” piece will be explained in a moment.

The net value of all the claims on a company’s assets can be broken down as follows:

Debt: Money that has been lent to the company by another person or institution. Debt holders
have a higher priority than equity holders on the claims of the company’s assets and value, so

they get paid first. In order to get to EV, we must add Debt to the Market Value of the company’s
Equity.

Cash: Money that is owned by the company—in other words, it’s sitting on the company’s
balance sheet. This money, assuming it is not required by the operations of the business, could

be used to pay off existing claimants, or stakeholders. (For example, the cash could be used to
pay off Debt; it could also be used to repurchase outstanding shares in the company’s Equity.)

Thus the higher the Cash balance a company has, the less its operations must be worth. This
concept is counterintuitive: shouldn’t owning more cash be a good thing? Yes, in a sense it is—

but assume for a moment that a company’s Market Value (of Equity) is fixed at a certain dollar
amount. That value can be ascribed to only two sources: (1) the residual claim value on a

company’s operations after all other stakeholders have been paid off, and (2) the value of the
money on the company’s balance sheet. The higher (2) is, the lower (1) is, and vice versa.

Therefore, to get to EV, we must subtract Cash from the Market Value of the company’s Equity.
(This is one way of looking at it. In practice, Cash is often subtracted from Debt to get an

important statistic called Net Debt. Net Debt is the value of the Debt once balance sheet Cash
has, hypothetically, been used to pay some of it off. Diagrams below will explain the different

ways of conceptualizing this.)

Minority Interest: This is a tricky one. Corporations often have a Liability account called

Minority Interest (MI). This is a special accounting designation for a specific scenario: when a
Corporation owns most, but not all, of a subsidiary company. If that is the case, the

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subsidiary company is consolidated entirely into the Corporation’s financial statements, so that it

would appear, at first glance, that the Corporation does indeed own 100% of that subsidiary. In
fact it does not, so this Liability account is created to represent the value of the shares owned in

the subsidiary by other individuals or companies. (Similarly, there will be a corresponding

Minority Interest expense on the Income Statement for the Corporation, representing the

portion of value from the subsidiary’s operating results that actually belongs to the other
shareholders in the subsidiary.) Since this MI represents the value of the partial ownership (by
others) in this subsidiary, it should be treated like Debt – that is, in order to get to EV, we must

add Minority Interest to the Market Value of the company’s Equity. (We should keep in mind,
then, that this EV statistic will include the entire value of the company’s subsidiary, even though

the Corporation itself does not own 100% of it.)

Preferred Equity: Despite the name, Preferred Equity primarily operates as Debt, not Equity.

It is junior to all other forms of Debt, but it is also senior to the Equity (often called Common
Equity or just “common.”) Often, Preferred Equity can be converted to shares of Common

Equity, hence the name. It may be convertible to Common Equity but, until that time, it receives
interest and is in line ahead of the Common Equity in the capital structure, so it is “preferred” to

the common shares. It receives preferential treatment. Because Preferred Equity is actually
primarily Debt unless and until it is converted to Equity, we must add Preferred Equity to the

Market Value of the company’s (Common) Equity.

Visually, we can look at this two different ways:

1. ENTERPRISE VALUE + CASH = TOTAL VALUE OF ALL CLAIMS

2. ENTERPRISE VALUE = NET VALUE OF ALL CLAIMS

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Typically, investment bankers and investors look at this equation the second way (the Net Debt/Net
Value version). This is the one to be most familiar with.

ANOTHER VIEW OF ENTERPRISE VALUE

There is another way of looking at EV: core assets vs. non-core assets. Core assets are used to generate
profit for the business; non-core assets are things owned by the business but not central to its money-

generating operations.

Core Assets: assets critical to the operating business, such as Inventory, Fixed Assets, Accounts
Receivable, etc.

Non-Core Assets: assets not critical to the operating business such as Derivatives, Currencies,
Real Estate, Commodities, Stock Options, etc.

In this sense, Cash on the Balance Sheet usually (at least for the most part) is non-core. Unless it’s cash
that the business needs to operate (such as dollar bills in the registers at a retail operations), it is not

being used to generate profit in the business operations. That’s why it is stripped out in EV calculations.
(Other non-core assets may be as well, especially if they can be sold off for cash without harming the
operations of the business. For example, Real Estate and Commodities can often be sold without
impacting the Company’s cash-generating operations.)

Therefore Cash is (generally) a non-core asset. Other similar assets, such as Marketable Securities, are
simply ways of attempting to earn profit on that Cash, but are not core to the company’s operations.
These Cash-like assets can also be sold off, and should be stripped out of the Net Debt Calculation.

PRIMARY COMPONENTS OF NET DEBT

(+) Short-Term Debt: Debt with less than one year maturity.
(+) Long-Term Debt: Debt with more than one year maturity.

(+) Debt Equivalents: Operating Leases and Pension Shortfalls.

(–) Cash and Cash Equivalents: Cash, Money Market Securities, and Investment Securities

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Notice in this list that “Cash and Cash Equivalents” is a subtraction from the calculation—Cash and
Cash-like assets are thus a sort of “anti-Debt.” Debt can also come in several different flavors, but on

the Balance Sheet it’s almost always broken down into Short-Term Debt and Long-Term Debt. This is
because Short-Term Debt is coming due soon (within less than a year), and thus must be paid off or
refinanced in the near future. This may be of interest if the company is having financial trouble—the
due date on the near-term Debt may trigger difficulties for the Company in terms of repayment. This

type of difficulty, which can end up being a crisis under the right circumstances, is called a liquidity
problem (or crisis).

Understanding Enterprise Value vs. Market Value

Nearly all valuation techniques will focus on either Enterprise Value or Market Value (or Equity). So
which do we use, and when? In a nutshell:

Techniques related to the value available to shareholders should focus on Market Value

(of Equity).
Similarly,
Techniques related to the value available to all stakeholders should focus on Enterprise
Value.

Let’s start by looking at three commonly used trading multiples:

EV/Sales: Enterprise Value ÷ Sales (or Revenue)

EV/EBITDA: Enterprise Value ÷ EBITDA (Earnings before Interest, Taxes, Depreciation &

Amortization)
Price/Earnings (or P/E): Market Value of Equity ÷ Net Income (alternatively, Stock Price ÷
Earnings Per Share, or EPS)

Notice that in the first two examples, Enterprise Value is used. This is because Sales and EBITDA
generate profit/value that is available to all stakeholders. No compensation has yet been taken out for
non-Equity stakeholders. By contrast, Price/Earnings reflects the Net Income for a company, which is
computed after compensation for other stakeholders has been removed (Interest Expense and

Minority Interest). Therefore, this profit/value is only available to Equity stakeholders.

People new to valuation may ask, “Why is it incorrect to use Market Value/EBITDA or Enterprise
Value/Net Income?” The answer lies in the fact that for any multiple, the denominator and numerator
within that multiple must either include or exclude leverage. In other words, both the numerator and

denominator must both relate to either all stakeholders or only shareholders. Otherwise, comparisons

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across companies will not be “apples-to-apples”—they will be difficult to compare because different
companies utilize different amounts of leverage.

This concept is demonstrated in the following graphic:

In summary:

Enterprise Value matches with Revenue, EBITDA and EBIT—items found before Interest

Expense (and Minority Interest, where applicable) on the Income Statement.

Conversely,
Market Value matches with Pre-Tax Income (sometimes called Earnings Before Taxes,
or EBT), Net Income, and Earnings Per Share—items found after Interest Expense (and
Minority Interest, where applicable) on the Income Statement.

An Introduction to Valuation Techniques

You will read about the four main valuation techniques for Investment Bankers in great detail in the
upcoming chapters. Here is a brief overview of them all, with this concept of Enterprise Value vs.
Market Value in mind:

COMPARABLE COMPANY ANALYSIS

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Comparable Company Analysis, frequently referred to simply as “Comps,” is a valuation

technique used to find company values based on traded values of similar (comparable)
companies.
Comps a market-based valuation analysis relying on current market prices for publicly traded
companies.
Comps valuation can revolve around either the Enterprise Value of the company or the

Market Value of the company, depending on the multiples being used. For example, EV/Sales
or EV/EBITDA multiples would refer to Enterprise Value, while Price/Earnings multiples
(equivalent to Market Value/Net Income) would refer to Market Value.

THE THREE MAIN STEPS OF A COMPS VALUATION

1. Identify publicly-traded companies with characteristics similar to those of the company being
valued.
2. “Spread” the Comps—i.e., map-out the trading multiples (EV/Sales, EV/EBITDA, and P/E) for

this set of comparable companies.

3. Assign these multiples to company financial results to determine valuation ranges.

COMPARABLE COMPANIES ANALYSIS EXAMPLE

ABC Company is currently generating annual Net Income of $150 million.

Publicly traded comparable companies are trading, on average, at 10x current year Net Income.
How much is the Equity of this company worth?

Using Comparable Company Analysis, this company’s Equity is worth $1.5 billion based on $150

million of Net Income and the comparable company average of 10x Net Income. Note that a proper
range of the valuation can be obtained by looking at the highest and lowest Net Income multiples in the
comparable companies set.

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DISCOUNTED CASH FLOW (DCF) ANALYSIS

DCF analysis values a company by projecting its future Free Cash Flows (FCF) and then using
the Net Present Value (NPV) method to value the firm.

DCF valuation builds off of Free Cash Flow forecasts that are typically done for the upcoming 5
to 10 years.
DCF valuation primarily returns the Enterprise Value of the company, because Free Cash
Flow refers to the cash generated by the operations of a business, irrespective of Net Debt and
Minority Interest/Preferred Equity. However a DCF model can also be used to project Market
Value if Interest Expense and Minority Interest are projected and stripped out to produce
Levered Free Cash Flows (LFCF).

THE FOUR MAIN STEPS OF A DCF VALUATION

1. Forecast out a company’s Free Cash Flows for the next 5-10 years.
2. Calculate the Weighted Average Cost of Capital (WACC).
3. Calculate the firm’s Terminal Value, or the future value of the firm assuming a stable long-
term growth rate.
4. Discount 5-year Free Cash Flows plus Terminal Value back to Year 0 (today) to derive the
Enterprise Value of the company.

Free Cash Flows are discounted back to Year 0 (today) to solve for Enterprise Value, as displayed in this

graphic:

PRECEDENT TRANSACTION ANALYSIS

Precedent Transaction Analysis, also called “Comparable Transactions,” looks at recent historical
M&A activity involving similar companies to get a range of valuation multiples.
This transaction valuation analysis relies on whatever historical M&A transaction information is
available.
Precedent Transaction valuation can revolve around either the Enterprise Value of the
company or the Market Value of the company, depending on the multiples being used. For

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example, EV/Sales or EV/EBITDA multiples would refer to Enterprise Value, while

Price/Earnings multiples (equivalent to Market Value/Net Income) would refer to Market Value.
The most commonly used transaction multiples are EV/Sales, EV/EBITDA, and P/E.

THE THREE MAIN STEPS OF PRECEDENT VALUATION

1. Identify publicly traded companies with similar characteristics.

2. “Spread” the comps or map-out trading multiples such as EV/Sales, EV/EBITDA, and P/E.
3. Assign industry multiples to company figures to determine valuation ranges.

PRECEDENT TRANSACTION ANALYSIS EXAMPLE

PDQ Company is currently generating annual Net Income of $150 million.

Precedent M&A transactions since 2004 have shown industry average of 20x P/E (see image
below).
How much is the Equity of this company worth?

Using Precedent Transaction Analysis, PDQ’s Equity is worth $3.0 billion based on $150 million of Net
Income and the precedent P/E multiple of 20x Net Income. Note that a proper range of the valuation

can be obtained by looking at the highest and lowest Net Income multiples in the precedent
transactions set.

LEVERAGED BUYOUT (LBO) ANALYSIS

An LBO is the acquisition of a public or private company with a significant amount of borrowed
funds. Leveraged Buyout Analysis is discussed later in this training module; it is also discussed

in great depth in the Private Equity Training Module.

LBO acquirers are typically Private Equity sponsors.
This is a transaction-based valuation technique. Private Equity buyers typically look to sell the
business within 5 years after purchase.
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LBO valuation revolves around the Enterprise Value of the company, because the entire
business will be acquired and all (or essentially all) of the pre-existing Debt will be paid off.

THE FIVE MAIN STEPS IN AN LBO ANALYSIS

1. Make transaction assumptions based on the purchase price, Debt interest rate, etc.

2. Build the Sources & Uses table, where “Sources” lists how the transaction will be financed and
“Uses” lists the capital uses—i.e., where the “Sources” money will be spent.
3. Adjust the Balance Sheet for the new Debt and Equity, and other transaction-related
adjustments.
4. Project out the three financial statements (usually 5 years) and determine how much Debt is paid
down each year.
5. Calculate exit value scenarios based on EBITDA multiples.

←Introduction Valuation Techniques Overview→

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