VALUATIONS BASIC ADVANCED & CALCS

1. What are the 3 major valuation methodologies?

Public Company Comparables (Public Comps), Precedent Transactions and the Discounted Cash Flow Analysis. Public Comps and Precedent Transactions are examples of relative valuation (based on market values), while the DCF is intrinsic valuation (based on cash flows).

2. Can you walk me through how you use Public Comps and Precedent Transactions?

First, you select the companies and transactions based on criteria such as industry, financial metrics, and geography (see the next question). Then, you determine the appropriate metrics and multiples for each set – for example, revenue, revenue growth, EBITDA, EBITDA margins, and revenue andEBITDA multiples – and you 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 those numbers to the financial metrics for the company you’re analyzing to estimate the potential range for its valuation. For example, if the company you’re valuing has $100 million in EBITDA and the median EBITDA multiple of the set is 7x, its implied Enterprise Value is $700 million based on that. You would then calculate its value at other multiples in this range.

3. How do you select Comparable Companies or Precedent Transactions?

The 3 main criteria for selecting companies and transactions: 1. Industry classification 2. Financial criteria (Revenue, EBITDA, etc.) 3. Geography For Precedent Transactions, you also limit the set based on date and often focus on transactions within the past 1-2 years. The most important factor is industry – that is always used to screen for companies/transactions, and the rest may or may not be used depending on how specific you want to be. Here are a few examples: • Comparable Company Screen: Oil & gas producers with market caps over $5 billion. • Comparable Company Screen: Digital media companies with over $100 million in revenue.Precedent Transaction Screen: Airline M&A transactions over the past 2 years involving sellers with over $1 billion in revenue. • Precedent Transaction Screen: Retail M&A transactions over the past year.

4. For Public Comps, you calculate Equity Value and Enterprise Value for use in multiples based on companies’ share prices and share counts… but what about for Precedent Transactions? How do you calculate multiples there?

They should be based on the purchase price of the company at the time of the deal announcement. For example, a seller’s current share price is $40.00 and it has 10 million shares outstanding. The buyer announces that it will pay $50.00 per share for the seller. The seller’s Equity Value in this case, in the context of the transaction, would be $50.00 * 10 million shares, or $500 million. And then you would calculate its Enterprise Value the normal way: subtract cash, add debt, and so on. You only care about what the offer price was at the initial deal announcement. You never look at the company’s value prior to the deal being announced.

5. How would you value an apple tree?

The same way you would value a company: by looking at what comparable apple trees are worth (relative valuation) and the present value of the apple tree’s cash flows (intrinsic valuation). Yes, you could build a DCF for anything – even an apple tree

6. When is a DCF useful? When is it not so useful?

A DCF is best when the company is large, mature, and has stable and predictable cash flows (think: Fortune 500 companies in “boring” industries). Your far-inthe-future assumptions will generally be more accurate there.A DCF is not as useful if the company has unstable or unpredictable cash flows (tech start-up) or when Debt and Operating Assets and Liabilities serve fundamentally different roles (ex: Banks and Insurance Firms – see the industryspecific guides for more).

7. What other Valuation methodologies are there?

Liquidation Valuation – Valuing a company’s Assets, assuming they are sold off and then subtracting Liabilities to determine how much capital, if any, equity investors receive. • LBO Analysis – Determining how much a PE firm could pay for a company to hit a “target” IRR, usually in the 20-25% range. • Sum of the Parts – Valuing each division of a company separately and adding them together at the end. • M&A Premiums Analysis – Analyzing M&A deals and figuring out the premium that each buyer paid, and using this to establish what your company is worth. • Future Share Price Analysis – Projecting a company’s share price based on the P / E multiples of the public company comparables and then discounting it back to its present value

8. When is a Liquidation Valuation useful?

It’s most common in bankruptcy scenarios and is used to see whether or not shareholders will receive anything after the company’s Liabilities have been paid off with the proceeds from selling all its Assets. It is often used to advise struggling businesses on whether it’s better to sell off Assets separately or to sell 100% of the company.

9. When would you use a Sum of the Parts valuation?

This is used when a company has completely different, unrelated divisions – a conglomerate like General Electric, for example.If you have a plastics division, a TV and entertainment division, an energy division, a consumer financing division, and a technology division, you should not use the same set of Comparable Companies and Precedent Transactions for the entire company. Instead, you should use different sets for each division, value each one separately, and then add them together to calculate the Total Value.

10. When do you use an LBO Analysis as part of your Valuation?

Clearly, you use this whenever you’re analyzing a Leveraged Buyout – but it is also used to “set a floor” on the company’s value and determine the minimum amount that a PE firm could pay to achieve its targeted returns. You often see it used when both strategics (normal companies) and financial sponsors (PE firms) are competing to buy the same company, and you want to determine the potential price if a PE firm were to acquire the company.

11. How do you apply the valuation methodologies to value a company?

You would present everything in a “Football Field” graph such as the one shown below:To do this, you need to calculate the minimum, 25th percentile, median, 75th percentile, and maximum for each set (2-3 years of comps and the transactions, for each different multiple used) and then multiply by the relevant metrics for the company you’re analyzing. Example: If the median EBITDA multiple from your set of Precedent Transactions is 8x and your company’s EBITDA is $500 million, the implied Enterprise Value would be $4 billion. For public companies, you will also work backwards to calculate the Equity Value and the implied Per Share Price based on this

1. Can you walk me through how to calculate EBIT and EBITDA? How are they different?

EBIT is just a company’s Operating Income on its Income Statement; it includes not only COGS and Operating Expenses, but also non-cash charges such as Depreciation & Amortization and therefore reflects, at least indirectly, the company’s Capital Expenditures. EBITDA is defined as EBIT plus Depreciation plus Amortization. You may sometimes add back other expenses as well (see the Advanced section). The idea of EBITDA is to move closer to a company’s “cash flow,” since D&A are both non-cash expenses… but there’s a problem with that since you’re also excluding CapEx altogether.

2. What about how you calculate Unlevered FCF (Free Cash Flow to Firm) and Levered FCF (Free Cash Flow to Equity)?

There are several methods (see the DCF section), but the simplest ways: Unlevered FCF = EBIT * (1 – Tax Rate) + Non-Cash Charges – Change in Operating Assets and Liabilities – CapEx With Unlevered FCF, you’re excluding interest income and expenses, as well as mandatory debt repayments. Levered FCF = Net Income + Non-Cash Charges – Change in Operating Assets and Liabilities – CapEx – Mandatory Repayments With Levered FCF, you’re including interest income, interest expense, and required principal repayments on the debt

3. What are the most common Valuation multiples? And what do they mean?

Enterprise Value / Revenue: How valuable is a company in relation to its overall sales. • Enterprise Value / EBITDA: How valuable is a company in relation to its approximate cash flow. • Enterprise Value / EBIT: How valuable is a company in relation to the pre-tax profit it earns from its core business operations. • Price Per Share / Earnings Per Share (P / E): How valuable is a company in relation to its after-tax profits, inclusive of interest income and expense and other non-core business activities. Other multiples include Price Per Share / Book Value Per Share (P / BV), Enterprise Value / Unlevered FCF, and Equity Value / Levered FCF. P / BV is not terribly meaningful for most companies; EV / Unlevered FCF is closer to true cash flow than EV / EBITDA but takes more work to calculate; andEquity Value / Levered FCF is even closer, but it’s influenced by the company’s capital structure and takes even more time to calculate.

4. How are the key operating metrics and valuation multiples correlated? In other words, what might explain a higher or lower EV / EBITDA multiple?

Usually, there is a correlation between growth and valuation multiples. So if one company is growing revenue or EBITDA more quickly, its multiples for both of those may be higher as well. However, math also plays a role and sometimes companies with extremely high EBITDA margins (for example) may have lower EBITDA multiples because EBITDA itself is much higher to begin with… and it’s in the denominator. Finally, keep in mind that plenty of other non-financial factors explain higher or lower multiples (see the “Real-World” section).

5. Why can’t you use Equity Value / EBITDA as a multiple rather than Enterprise Value / EBITDA?

Remember our funnel chart from the previous section on Equity Value and Enterprise Value (see: right image). If the metric includes interest income and expense, you use Equity Value; if it excludes them (or is “before” them), you use Enterprise Value. EBITDA is available to all investors in the company – not just common shareholders. Similarly, Enterprise Value is also available to all investors since it includes Equity and Debt, so you pair them together. Calculating Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect the company’s entire capital structure – only what’s available to common shareholders.

6. What would you use with Free Cash Flow multiples – Equity Value or Enterprise Value?

Trick question. For Unlevered Free Cash Flow (Free Cash Flow to Firm), you would use Enterprise Value, but for Levered Free Cash Flow (Free Cash Flow to Equity) you would use Equity Value (see the diagram above). Remember, Unlevered Free Cash Flow excludes Interest (and mandatory debt repayments) and thus represents money available to all investors, whereas Levered FCF already includes the effects of Interest expense (and mandatory debt repayments) and the money is therefore only available to equity investors. Debt investors have already “been paid” with the interest payments and principal repayments they received.

7. Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?

Warren Buffett once famously asked, "Does management think the tooth fairy pays for capital expenditures?” He dislikes EBITDA because it hides the Capital Expenditures companies make and disguises how much cash they require to finance their operations. In some industries there is also a large gap between EBIT and EBITDA – anything that is capital-intensive and asset-heavy, for example, will show a big disparity. Note that EBIT itself does not include Capital Expenditures, but it does include Depreciation and that is directly linked to CapEx – that’s the connection. If a company has a high Depreciation expense, chances are it has high CapEx spending as well.

8. What are some problems with EBITDA and EBITDA multiple? And if there are so many problems, why do we still use it?

First, it hides the amount of debt principal and interest that a company is paying each year, which can be very large and may make the company cash flow negative; as mentioned above, it also hides CapEx spending, which can also be huge. EBITDA also ignores working capital requirements (e.g. Accounts Receivable, Inventory, Accounts Payable), which can be very large for some companies. Finally, companies like to “add back” many charges and expenses to EBITDA, so you never really know what it represents unless you dig into it in-depth. So in many cases, EBITDA is not even close to true “cash flow” – it is widely used mostly because of convenience (it’s easy to calculate) and because it has become a standard over time. Another argument for EBITDA is that although it’s not close to cash flow, it’s better for comparing the cash generated by a company’s core business operations than other metrics – so you could say that EBITDA is more about comparability than cash flow approximation.

9. The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company’s profitability. What’s the difference between them, and when do you use each one?

P / E depends on the company’s capital structure, whereas EV / EBIT and EV / EBITDA are capital structure-neutral. Therefore, you use P / E for banks, insurance firms, and other companies where interest is critical and where capital structures tend to be similar. EV / EBIT includes Depreciation & Amortization, whereas EV / EBITDA excludes it – you’re more likely to use EV / EBIT in industries where D&A is large and where Capital Expenditures and fixed assets are important (e.g. manufacturing), and EV / EBITDA in industries where fixed assets are less important and where D&A is comparatively smaller (e.g. Internet companies). NOTE: Many bankers get this logic reversed and think that EV / EBITDA is better when CapEx and Depreciation are both large… which is not correct, if you take a second to think about it. If they start arguing about it an interview, just give in and agree with what they say.

10. Could EV / EBITDA ever be higher than EV / EBIT for the same company?

No. By definition, EBITDA must be greater than or equal to EBIT because to calculate it, you take EBIT and then add Depreciation & Amortization, neither of which can be negative (they could, however, be $0, at least theoretically). Since EBITDA is always greater than or equal to EBIT, EV / EBITDA must always be less than or equal to EV / EBIT for a single company.

11. What are some examples of industry-specific multiples?

Technology (Internet): EV / Unique Visitors, EV / Pageviews • Retail / Airlines: EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rental Expense) • Oil & Gas: EV / EBITDAX (Earnings Before Interest, Taxes, Depreciation, Amortization & Exploration Expense), EV / Production, EV / Proved Reserves • Real Estate Investment Trusts (REITs): Price / FFO per Share, Price / AFFO per Share (Funds from Operations, Adjusted Funds from Operations) Technology and Oil & Gas should be straightforward – you’re looking at website traffic and energy reserves as value drivers rather than revenue or profit. For Retail / Airlines, you add back Rent because some companies own their own buildings and capitalize the expense whereas others rent and therefore have a rental expense. This one is about comparability rather than cash flow approximation. The EBITDAX metric for Oil & Gas exists because some companies capitalize (a portion of) their exploration expenses and some expense them. You add back the exploration expense to normalize the numbers – once again, comparability, not cash flow. For REITs, Funds from Operations is a common metric that adds back Depreciation and subtracts Gains (and adds Losses) on the sale of property. Depreciation is a non-cash yet extremely large expense in real estate, and Gains and Losses on property sales are assumed to be non-recurring, so FFO is a more “normalized” picture of earnings than Net Income

12. When you’re looking at an industry-specific multiple like EV / Proved Reserves or EV / Subscribers (for telecom companies, for example), why do you use Enterprise Value rather than Equity Value?

You use Enterprise Value because those Proved Reserves or Subscribers are “available” to all the investors (both debt and equity) in a company. This is almost always the case unless the metric already includes interest income and expense (FFO and AFFO above).

1. Rank the 3 main valuation methodologies from highest to lowest expected value.

Trick question – there is no ranking that always holds up. In general, Precedent Transactions will be higher than Comparable Public Companies due to the Control Premium built into acquisitions (i.e. the buyer must pay a premium over a company’s current share price to acquire it).Beyond that, a DCF could go either way and it’s best to say that it’s more variable than other methodologies. Often it produces the highest value, but it can produce the lowest value as well depending on your assumptions.

2. Would an LBO or DCF produce a higher valuation?

Technically it could go either way, but in most cases the LBO will give you a lower valuation. Here’s the easiest way to think about it: with an LBO, you do not get any value from the cash flows of a company in between Year 1 and the final year – you only get “value” out of its final year. With a DCF, by contrast, you’re taking into account both the company’s cash flows in the period itself and its terminal value, so values tend to be higher. Note: Unlike a DCF, an LBO model by itself does not give a specific valuation. Instead, you set a desired IRR and back-solve for how much you could pay for the company (the valuation) based on that. See the LBO section of the guide for more

3. When would a Liquidation Valuation produce the highest value?

This is highly unusual, but it could happen if a company had substantial hard assets but the market was severely undervaluing it for a specific reason (such as an earnings miss or cyclicality). As a result, the Comparable Companies and Precedent Transactions would likely produce lower values as well – and if its assets were valued highly enough, Liquidation Valuation might give a higher value than other methodologies.

4. Why are Public Comps and Precedent Transactions sometimes viewed as being “more reliable” than a DCF?

It’s because they’re based on actual market data, as opposed to assumptions far into the future. Note, however, that you still do make future assumptions even with these (for example, the “Forward Year 1” and “Forward Year 2” multiples in the graphs above are based on projections for each company in the set). Also note that sometimes you don’t have good or truly comparable data for these, in which case a DCF may produce better results.

5. What are the flaws with Public Company Comparables?

No company is 100% comparable to another company. • The stock market is “emotional” – your multiples might be dramatically higher or lower on certain dates depending on the market’s movements. • Share prices for small companies with thinly-traded stocks may not reflect their full value.

6. You mentioned that Precedent Transactions usually produce a higher value than Comparable Companies – can you think of a situation where this is not the case?

Sometimes this happens when there is a substantial mismatch between the M&A market and the public markets. For example, no public companies have been acquired recently but lots of small private companies have been acquired at low valuations. For the most part this generalization is true but there are exceptions to almost every “rule” in finance. And if you want proof, just take a look at the valuation graph we’ve been using throughout this part of the guide

7. What are some flaws with Precedent Transactions?

Past transactions are rarely 100% comparable – the transaction structure, size of the company, and market sentiment all make a huge impact. • Data on precedent transactions is generally more difficult to find than it is for public company comparables, especially for acquisitions of small, private companies.

1. How would you present these Valuation methodologies to a company or its investors? And what do you use it for?

Usually you use a “Football Field” chart where you show the valuation range implied by each methodology. You always show a range rather than one specific number. Once again, see the graph we’ve been using throughout this section of the guide for an example. You could use a Valuation for: • Pitch Books and Client Presentations – When you provide updates and tell them what you think they’re worth. • Parts of Other Models – Defense analyses, merger models, LBO models, DCFs, and almost everything else in finance will incorporate a Valuation in some way. • Fairness Opinions – Right before a deal with a public seller closes, its financial advisor creates a “Fairness Opinion” that justifies the acquisition price and directly estimates the company’s valuation.

2. Why would a company with similar growth and profitability to its Comparable Companies be valued at a premium?

The company has just reported earnings well-above expectations and its stock price has risen in response. • It has some type of competitive advantage not reflected in its financials, such as a key patent or other intellectual property. • It has just won a favorable ruling in a major lawsuit. • It is the market leader in an industry and has greater market share than its competitors

3. How do you take into account a company’s competitive advantage in a valuation?

1. Highlight the 75th percentile or higher for the multiples rather than median. 2. Add in a premium to some of the multiples. 3. Use more aggressive projections for the company. In practice you rarely do all of the above – these are just possibilities

4. Do you ALWAYS use the median multiple of a set of public company comparables or precedent transactions?

Nope. In fact, you almost always show a range. And you may make the median the center of that range, but you don’t have to – you could focus on the 75th percentile, 25th percentile, or anything else if the company is outperforming or underperforming for some reason.

5. Two companies have the exact same financial profiles (revenue, growth, and profits) and are purchased by the same acquirer, but the EBITDA multiple for one transaction is twice the multiple of the other transaction – how could this happen?

One process was more competitive and had a lot more companies bidding on the target. • One company had recent bad news or a depressed stock price so it was acquired at a discount.They were in industries with different median multiples. • The two companies have different accounting standards and have added back different items when calculating EBITDA, so the multiples are not truly comparable.

6. If you were buying a vending machine business, would you pay a higher EBITDA multiple for a business that owned the machines and where they depreciated normally, or one in which the machines were leased? The Depreciation expense and the lease expense are the same dollar amounts and everything else is held constant

You would pay a higher multiple for the one with leased machines if all else is equal. The Purchase Enterprise Value would be the same for both acquisitions, but Depreciation is excluded from EBITDA – so EBITDA is higher, and the EV / EBITDA multiple is lower for the one that owns its own machines. For the company with leased machines, the lease expense would show up in Operating Expenses, making EBITDA lower and the EV / EBITDA multiple higher. This goes back to one of the points we’ve made throughout this guide: in isolation, specific valuation multiples don’t mean much. You need to see what goes into the numbers and what standards are used. In this case, it would be more meaningful to use an EBIT or EBITDAR multiple to compare the two potential acquisitions.

7. How would you value a company that has no profit and no revenue

1. You could use Comparable Companies and Precedent Transactions and look at more “creative” multiples such as EV / Unique Visitor and EV/Pageviews (for Internet start-ups, for example) rather than EV / Revenue or EV / EBITDA. 2. You could use a “far-in-the-future DCF” and project a company’s financials out until it actually earns revenue and profit. Method #1 is better for Internet start-ups and anything else that is truly unpredictable; method #2 is more common for biotech and pharmaceutical companies, where you can more predictably estimate the potential market size and prices for new drugs.

8. The S&P 500 Index (or equivalent index in other country) has a median P / E multiple of 20x. A manufacturing company you’re analyzing has earnings of $1 million. How much is the company worth?

It depends on how it’s performing relative to the index, and relative to companies in its own industry. If it has higher growth and/or higher margins, you may assign a higher multiple to it – maybe 25x or even 30x, and therefore assume that its Equity Value equals $25 million or $30 million. If it’s on par with everyone else, then maybe its valuation is just $20 million. And if it’s underperforming, perhaps it’s lower than that. Qualitative factors, such as management team and market position, also come into play and may determine the appropriate multiple to use.

9. A company’s current stock price is $20.00 per share, and its P / E multiple is 20x, so its EPS is $1.00. It has 10 million shares outstanding. Now it does a 2-for-1 stock split – how do its P / E multiple and valuation change?

They don’t. Think about what happens: the company now has 20 million shares outstanding… but its Equity Value has stayed the same, so its share price falls to $10.00. Its EPS falls to $0.50, but its share price has also fallen to $10.00, so the P / E multiple remains 20x. Splitting stock into fewer units or additional units doesn’t, by itself, make a company worth more or less. However, in practice, often a stock split is viewed as a positive sign by the market… so in many cases a company’s value will go up and its share price won’t necessarily be cut in half, so P / E could increase

10. Let’s say that you’re comparing a company with a strong brand name, such as Coca-Cola, to a generic manufacturing or transportation company. Both companies have similar growth profiles and margins. Which one will have the higher EV / EBITDA multiple?

In all likelihood, Coca-Cola will have the higher multiple due to its strong brand name. Remember that valuation is not a science – it’s an art, and the market often behaves in irrational ways. Values are not based strictly on financial criteria, and other factors such as brand name, perceived “trendiness,” and so on all make a huge impact.

5. How do you value Net Operating Losses (NOLs) and take them into account in a valuation?

You determine how much the NOLs will save the company in taxes in future years, and then calculate the net present value of the total future tax savings. There are two ways to estimate the tax savings in future years: 1. Assume that a company can use its NOLs to completely offset its taxable income until the NOLs run out. 2. In an acquisition scenario, use Section 382 and multiply the highest adjusted long-term rate of the past 3 months by the Equity Purchase Price of the seller to determine themaximum allowed NOL usage in each year – and then use that to determine how much the company can save in taxes. You might look at NOLs in a valuation but you rarely factor them in – if you did, they would be treated similarly to Cash and you would subtract NOLs to go from Equity Value to Enterprise Value, and vice versa (see the Equity Value and Enterprise Value section of the guide).

5. You’re analyzing the financial statements of a Public Comp, and you see Income Statement line items for Restructuring Expenses and an Asset Disposal. Should you add these back when calculating EBITDA?

This is a trick question on multiple levels: 1. First, you should always take these charges from the Cash Flow Statement if possible – sometimes the charges are partially embedded within other line items on the Income Statement. If they don’t appear on the Cash Flow Statement, look up them in the Notes to the Financial Statements. 2. Second, you only add them back if they’re truly non-recurring charges. If a company claims it has been “restructuring” for the past 5 years, well, that’s not exactly a non-recurring expense. There’s a lot of subtlety when adjusting for these types of charges and there is not necessarily a “correct” way to do it in all cases.

1. How do you value a private company?

You use the same methodologies as with public companies: public company comparables, precedent transactions, and DCF. But there are some differences: • You might apply a 10-15% (or more) discount to the public company comparable multiples because the private company you’re valuing is not “liquid” like the public comps are. • You can’t use a premiums analysis or future share price analysis because a private company doesn’t have a share price. • Your valuation shows the Enterprise Value for the company as opposed to the implied per-share price as with public companies. You can still calculate Equity Value, but a “per-share price” is meaningless for a private company. • A DCF gets tricky because a private company doesn’t have a market capitalization or Beta – you would probably estimate WACC based on the public comps’ WACC rather than trying to calculate it yourself.