Chapter 1: Comparable Method (1.1&1.2)

Company Valuation

Overview of Company Valuation

• Total Company Value (V):- Represents the total value of a company's assets.

  • It is the combined value of the company's stock (equity) and bonds or loans (debt).

  • Expressed as the equation: $V = D + E$ - Where $V$ = Value, $D$ = Debt, $E$ = Equity.

  • Bondholders: Are promised future cash payments (interest and principal) from the company's cash flows.

  • Stockholders: Receive the remaining cash flows, either through dividends or reinvestment, which increases share value.

• Capital Structure:- The proportion of debt and equity a company chooses to finance its assets.

  • The chosen capital structure can influence a company's total value.

When and Why Company Valuation is Essential

• Acquisitions: To determine the fair price to pay when acquiring a company.

• Investments: To assess whether the price of a company's stock or bond is "fair" before investing.

• Management Decisions: To understand how strategic decisions will impact the company's value.

• Importance of Accuracy: Inaccurate valuations can lead to significant financial issues, as exemplified by WeWork, which was once valued at $47 \text{ billion}$ but later warned of potential bankruptcy.

Book Value vs. Market Value

• Book Value:- Values calculated based on accounting conventions, typically using acquisition or historical costs.

  • Represented on the Balance Sheet via accounting rules.

• Market Value (Focus of Valuation):- A forward-looking measure reflecting what investors are willing to pay for a company's assets today.

  • Represents the company's economic value now.

  • Market Value Equation: Assets = Liabilities + Equity (updated by accounting rules on the Balance Sheet).

  • Market Debt: Refers to current value from the open market, typically interest-bearing liabilities only.

Market Equity Value

• Also known as Market Capitalization.

• The value represented by a company's basic shares outstanding plus "in-the-money" stock options, warrants, and convertible securities.

• These components collectively form "fully diluted shares outstanding."

• Formula: $\text{Equity Value} = \text{Share Price} \times \text{Fully Diluted Shares Outstanding}$

• Components of Fully Diluted Shares Outstanding:- Basic Shares Outstanding

  • "In-the-Money" Options and Warrants

  • "In-the-Money" Convertible Securities

• Stock Options: Non-cash compensation for employees, providing the right to buy shares at a set "exercise" or "strike" price within a specific period.

• Warrants: Securities, typically issued with debt, granting the purchaser the right to buy shares at a set price during a given period.

• Convertible Securities: Financial instruments, like bonds, that can be profitably converted into stock.

Enterprise Value

• A comprehensive measure of a company's total value, often used as an alternative to market capitalization.

• Formula: $\text{Enterprise Value} = \text{Market Value of Equity} + \text{Market Value of Debt} + \text{Market Value of Preferred Stock} + \text{Noncontrolling Interest} - \text{Nonoperating Assets}$

• In some practical examples, components like Market Value of Preferred Stock, Noncontrolling Interest, and Nonoperating Assets may be assumed to be zero (e.g., Microsoft converted all preferred shares into common shares in 1999).

• Examples of its use include valuing companies like SpaceX and LG CNS for IPOs or growth projections.

How the Market Decides the Value of a Company: Valuation Models

• To determine a company's value, a valuation model must be chosen based on two principles:1. Law of One Price: Equivalent assets that can be freely bought and sold will have the same market price.

  2. Model Limitations: Every model is an incomplete, simplified description of a complex reality, meaning no model is perfect.

• Two Most Commonly Used Valuation Models:- Valuation using Comparables

  • Discounted Cash Flow (DCF) Analysis

Valuation Using Comparables

• Definition: A valuation method that uses relevant information from comparable (ideally identical) companies.

• Logic: Based on the Law of One Price; if an identical company's value is known, it can estimate the value of the target company.

• Problem: No two companies are completely identical. However, close competitors in the same industry can provide useful information.

• Methodology: Calculate the total value using multiples or ratios derived from comparable companies.

• Solution: Use a single comparable company or, more commonly, an average/median across a set of comparable companies.

Requirements for Valuation using Comparables

• Similar Business Risks: Comparable companies should have similar business risks.

• Identification: Use industry classification systems such as MSCI/Standard & Poor's Global Industry Classification Standard (GICS) or FTSE Industry Classification Benchmark (ICB).

• GICS Classification: Comparable companies are typically in the same tier of classification (sectors, industry groups, industries, and sub-industries).

• Approach: Estimate the average or median of a chosen multiple for all comparable companies in the selected tier and apply it to the firm being valued.

Example 1: Zara's Enterprise Value

• Scenario: Zara's current earnings (EBITDA) are $10 \text{ million}$ . H&M (a comparable company) has an Enterprise Value to EBITDA (EV/EBITDA) ratio of $20.00$ .

• Calculation: $V = \text{EBITDA} \times \text{EV/EBITDA}_{\text{comparable}} = 10 \text{ mln} \times 20.00 = 200 \text{ mln}$ .

Other Cases: Equity/Stock Valuation

• When estimating the price of a company's equity or stock, the same methodology applies using different ratios.

• Price-to-Earnings (P/E) Ratio: A common ratio for valuing stock.

• Formula: $\text{Stock Price} = \text{EPS} \times \text{(P/E)}_{\text{comparable}}$

Pros & Cons of Comparables (General)

• Benefits (Pros):- Does not require extensive detailed data or future projections.

  • Quick and straightforward, providing a rapid initial valuation.

  • Useful for newly public or private companies.

• Limitations (Cons):- Accuracy highly dependent on identifying truly comparable companies.

  • Estimates can be significantly off if comparables are poor.

  • Solution: Analysts typically average ratios from multiple comparable companies within the same industry.

Example 2: Coca-Cola's Total Value

• Scenario: Estimate Coca-Cola's total value using PepsiCo Inc. as a comparable.- Coca-Cola's EBITDA (March 2024): $14.65 \text{ billion}$ .

  • PepsiCo's EV/EBITDA ratio: $18.11$ .

• Model's Estimate: $V = 14.65 \text{ bln} \times 18.11 = 265.31 \text{ bln}$ .

• Actual Enterprise Value (March 2024): $297.16 \text{ bln}$ .

• Difference: Approximately $31.8 \text{ billion}$ .

• Reasons for Discrepancy (Why the estimate is off):- Market's assessment might indicate overvaluation for Coca-Cola, though market price is generally considered the best estimate.

  • The comparable firm (PepsiCo) might not be perfectly comparable due to diverse business segments (e.g., PepsiCo's food brands like Lays and Doritos).

• Solution: Decompose the target company into major divisions and apply a comparable EV/EBITDA ratio for each distinct business component. This highlights the importance of deeply understanding the company's operations.

Group Activity Summary on Comparables

• Reaffirms that even "comparable" companies are unique and rarely identical.

• Emphasizes selecting an appropriate Enterprise Value-to-EBITDA multiple range, which is then applied to the target's financial statistics to derive an implied valuation range.

Example 3: Katsuya's Restaurants Stock Valuation

• Scenario: Katsuya's market price: $80$ /share. Similar restaurants' P/E ratio: $15$ . Katsuya's EPS: $5$ /share.

• Estimated Value: $\text{Stock Price} = \text{EPS} \times \text{(P/E)}_{\text{comparable}} = 5 \times 15 = 75$ /share.

• Comparison: Market price ($80$ ) is greater than the estimated value ($75$ ).

• Conclusion: The stock is overpriced (Option B).

Example 4: Investment Decision Based on Valuation Model

• Principle: If an investor believes their valuation model's assessment more than the market's, they should invest when their estimated intrinsic value is greater than the market price (Option A).

Detailed Pros & Cons of Comparables

• Pros:- Market-based: Utilizes actual public market data, reflecting market growth, risk expectations, and overall sentiment.

  • Relativity: Easily measurable and comparable against other companies.

  • Quick and convenient: Valuation derived with minimal, easily calculable inputs.

  • Current: Based on prevailing market data, allowing for frequent updates.

• Cons:- Market-based Limitations: Valuation can be distorted during periods of irrational market exuberance or bearishness.

  • Absence of relevant comparables: Difficult, or impossible, to find "pure play" comparables, especially for niche sectors, which reduces the meaningfulness of the valuation.

  • Potential disconnect from cash flow: Valuations based on market conditions may significantly differ from valuations implied by projected cash flow generation (e.g., DCF analysis).

  • Company-specific issues: Relies on other companies' valuations, potentially failing to capture the target's unique strengths, weaknesses, opportunities, and risks.