LINCOLN INTERNATIONAL PREP
Valuation Methodologies
The three most commonly used methodologies for valuation are:
Discounted Cash Flow (DCF) Analysis: This method values a company by projecting its future cash flows and then discounting these projected cash flows to their present value. It focuses on the intrinsic value of an investment.
Comparable Company Analysis (CCA): This method values a company by comparing it to other similar businesses. The comparison is based on criteria such as size, industry, margins, profitability, growth rate, and geography, using valuation multiples.
Precedent Transaction Analysis (PTA): This method estimates a company's implied value by evaluating the acquisition prices paid for similar companies in recent transactions. It considers the prices under similar circumstances to determine what a stock share would be worth in an acquisition.
Equity Value vs. Enterprise Value
Enterprise Value (EV):
Represents the total value of a company, encompassing the current share price and the cost to pay off all debt. It provides an in-depth insight into a company's overall financial health, considering both ownership value and debt owed.
Formula: EV = ext{Equity Value} + ext{Debt} + ext{Preferred Stock} + ext{Noncontrolling Interest} - ext{Cash}
It is crucial for comparing companies with different capital structures because it represents the firm's value independent of how it is financed.
Equity Value:
Represents the value of a company's ownership that remains for investors after all its debts have been paid off.
Also known as market capitalization (Market Cap), which is calculated as ext{Shares Outstanding} imes ext{Share Price}.
Relationship: To get Enterprise Value from Equity Value, you add debt and subtract cash. This highlights that EV represents the entire company's value, while Equity Value only reflects the shareholders' stake.
Incorporating Intangible Assets in Valuation
The process for valuing intangible assets involves:
Identification and Specification: First, clearly identify and specify the intangible assets in question.
Impact Evaluation: Next, evaluate their impact on the company's financial performance.
Net Asset Value Calculation: Calculate the value of these net assets and record it on the company's balance sheet, noting the difference from the overall business valuation.
Example: For intangible assets like patents and intellectual property, the calculated intangible value method is often used.
Preparing Pitch Books
The steps for preparing a pitch book are:
Client Requirements and Objectives: Determine the client's specific requirements and objectives to highlight key information they wish to communicate.
Research: Research relevant tax laws and regulations, along with the company's financial information, to identify any tax-related issues or opportunities that might affect or benefit the company.
Organization and Formatting: Based on the analysis, organize this information in a clear format using concise language.
Visual Aids: Include visual aids such as graphs, charts, and tables.
Standard Template: Follow a standard template that typically includes a title page, executive summary, bank introduction, market overview, valuation, transaction strategy, and summary.
Discounted Cash Flow (DCF) Analysis Explained
Definition: DCF is a valuation method that estimates the value of an investment by using its expected future cash flows and discounting them to their present value.
Purpose: Analysts use DCF to determine an investment's value today based on projections of its future cash generation. It helps investors considering acquiring a company or buying securities, and assists business owners/managers in capital budgeting or operating expenditure decisions.
Key Component: Weighted Average Cost of Capital (WACC):
WACC is used as the discount rate in DCF models to value a company’s future cash flows. It represents the average after-tax cost of capital from all sources (common stock, preferred stock, bonds, other debt).
It also represents the average rate that a company expects to pay to finance its business.
Walk-through a DCF Analysis:
Project Free Cash Flows (FCFs): Project the company’s free cash flows over a specific period, typically 5 to 10 years (usually 5 years).
To arrive at FCF from Revenue:
Start with Revenue.
Subtract Cost of Goods Sold (COGS) to get Gross Profit.
Subtract all operating costs (or operating expenses), including Selling, General, & Administrative (SG&A) and Research & Development (R&D).
Subtract Depreciation to arrive at EBIT (Earnings Before Interest and Taxes).
Account for taxes (using (1-T)) to get NOPAT (Net Operating Profit After Tax).
Add back Depreciation (since it's a non-cash expense).
Subtract Capital Expenditures (CapEx).
Subtract Changes in Net Working Capital (NWC).
Discount FCFs: Discount these projected FCFs to their present value using the company's WACC.
Calculate Terminal Value (TV): Determine the value of the business beyond the forecasted period.
Perpetual Growth Model (PGM) / Gordon Growth Model: TV = ( ext{FCF}_{ ext{last projected year}} imes (1+g)) / ( ext{WACC}-g), where g is the stable growth rate.
Exit Multiple Method (MsM): Multiply the last year's EBITDA (or other metric) by an appropriate exit multiple, then discount this value back to the present.
Discount Terminal Value: Discount the calculated terminal value back to its present value using WACC.
Sum for Overall Valuation: Add the present value of the projected FCFs and the present value of the terminal value to determine the company’s overall Enterprise Value (EV).
Calculate Equity Value and Share Price: Subtract net debt (Debt - Cash) from the Enterprise Value to find the Equity Value, then divide by the number of Shares Outstanding (SHO) to get the implied share price.
Pros of DCF:
If confident in assumptions, it is considered the most sound method as it values individual cash streams.
It is not affected by temporary market conditions.
Provides an intrinsic value based on future performance.
Cons of DCF:
Highly sensitive to assumptions, leading to wildly different valuations.
Forecasting future performance is subjective, and conditions can change significantly over 5-10 years.
Can be unreliable for companies with unpredictable, negative, or highly variable cash flows (e.g., some biopharma companies).
Weighted Average Cost of Capital (WACC)
Definition: WACC is a company's average after-tax cost of capital from all sources, including common stock, preferred stock, bonds, and other forms of debt.
Formula: WACC = (E/V imes Re) + ((D/V imes Rd) imes (1 - T))
E: Market value of equity
D: Market value of debt
V = E+D: Total market value of equity and debt
R_e: Cost of equity
R_d: Cost of debt
T: Corporate tax rate
Cost of Debt: Readily observable in the market as the yield on debt with equivalent risk.
Cost of Equity: Typically estimated using the Capital Asset Pricing Model (CAPM), linking expected equity return to market sensitivity.
Impact of Debt: Having debt can lower the WACC because the cost of debt is normally less than the cost of equity (due to tax deductibility and lower risk for creditors). However, high levels of debt increase business risk, which can raise the overall WACC.
Capital Asset Pricing Model (CAPM)
Purpose: Used to calculate the cost of equity (R_e), which is an input in the WACC formula.
Formula: R_e = ext{Risk Free Rate} + ext{Beta} imes ext{Equity Risk Premium}
Risk-Free Rate: The return on a risk-free investment (e.g., government bonds).
Beta: A measure of the stock's volatility (systematic risk) in relation to the overall market.
Equity Risk Premium (ERP): The difference between the expected return on the overall market (Em) and the risk-free rate (Rf): ERP = (Em - Rf ext{ rate}).
Beta for a Private Company
Since private companies do not have publicly traded shares, their betas cannot be directly observed. The process involves:
Find Comparable Companies (Comps): Identify publicly traded companies similar to the private company.
Unlever Betas: Unlever the betas of these comparable companies to remove the effects of their individual capital structures.
Average Unlevered Beta: Calculate the average of these unlevered betas.
Re-lever Beta: Re-lever the average beta for the private company using its specific (target) capital structure.
Comparable Company Analysis (CCA) Explained
Definition: CCA is a valuation method that values a company by comparing its metrics (e.g., valuation multiples) to those of other businesses of similar size and in the same industry.
Assumption: It operates under the assumption that similar companies will have similar valuation multiples (e.g., EV/EBITDA, P/E ratio).
Process: Analysts compile statistics and calculate valuation multiples for target and comparable companies to make comparisons.
Pros:
Values tend to be reliable if a good number of truly comparable companies exist, allowing for accurate median or percentile analysis.
Data is current, reflecting present market conditions.
Cons:
No two companies are perfectly alike, making it challenging to find truly comparable companies.
Differences in product lines, segments, or operations can make direct comparisons difficult.
Precedent Transaction Analysis (PTA) Explained
Definition: PTA determines a company's value by evaluating recent acquisition prices paid for similar companies in the past.
Outcome: It creates an estimate of what a share of stock would be worth in the case of an acquisition, often reflecting a control premium.
Pros:
Often implies a higher valuation due to the inclusion of a control premium (what a buyer pays to acquire control).
When required data is public, it can be a relatively easy valuation method.
Cons:
Valuations are highly influenced by temporary market conditions and can fluctuate significantly over time.
It's challenging to find truly comparable transactions, as deals vary by size, market sentiment, and specific circumstances (e.g., a transaction from a boom market might imply an artificially high valuation in a downturn).
It is less comparable than CCA due to the unique nature of each transaction.
Key Financial Metrics & Ratios
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization):
A measure of a company's core profitability, designed to exclude the effects of financing (interest), accounting decisions (depreciation, amortization), and tax policy.
EV/EBITDA (Enterprise Value to EBITDA):
A widely used valuation multiple that compares the total value of the business (Enterprise Value) to its core earnings (EBITDA).
Why it's common: It helps compare companies with different capital structures by removing the effects of financing and accounting decisions. Particularly useful within the same industry or sector.
Use cases: Helps assess the company’s overall financial health and compare it to peers.
P/E Ratio (Price-to-Earnings):
Compares a company’s stock price to its earnings per share (EPS).
Indicates how much investors are willing to pay for each dollar of earnings.
Revenue Multiples:
Often used for companies that do not yet have positive EBITDA (e.g., small tech startups, early-stage growth companies).
Zero Coupon Bond:
A debt security instrument that does not pay periodic interest (coupons).
It is sold at a discount to its face value and matures at par (full face) value. The difference between the purchase price and the face value is the bondholder's return.
Valuation Differences Despite Same EBITDA
Two companies with the same EBITDA can have different valuations due to various factors:
Growth Potential: Higher projected cash flow growth typically results in a higher valuation (net positive growth vs. net negative growth).
Leverage / Net Leverage: Higher debt generally increases risk, leading to a lower valuation. Companies with higher debt loads are valued less.
Risk Profile: More debt or negative growth prospects can make a company riskier, thus lowering its valuation. A higher risk profile commands a lower multiple.
Ratios Creditors Look At
Long-Term Ratios:
Debt Ratio: Total Debt / Total Assets. Indicates the proportion of a company's assets financed by debt.
Debt to Equity Ratio (D/E): Total Debt / Shareholder Equity. A lower D/E ratio indicates lower financial risk and a better ability to repay debt.
Short-Term Ratios (Liquidity Ratios):
Current Ratio: Current Assets / Current Liabilities.
Quick Ratio (Acid-Test Ratio): (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities.
These ratios focus on the company’s ability to cover short-term obligations and understand its cash flow position.
Overall Financial Health:
EV/EBITDA: Provides a clear sense of the monetary worth of the company relative to its operating earnings, which is important for creditors to assess the company's capacity to service its debt.
Example Scenario: If a company has 10 ext{ million EBITDA}, a 10x EV/EBITDA multiple, and 150 ext{ million in debt}. Its Enterprise Value would be 10 ext{ million} imes 10 = 100 ext{ million}. If the debt is 150 ext{ million}, and there is no cash, the Equity Value would be negative, suggesting the company is overleveraged or the implied multiple is too high given the debt.
Financial Statement Linkages: Transactions Walk-through
Income Statement (IS)
Shows a company’s profitability over a specific period.
Items: Revenue, Cost of Goods Sold (COGS), Selling, General & Administrative (SG&A), Research & Development (R&D), Earnings Before Interest & Taxes (EBIT), Interest Expense, Earnings Before Tax (EBT), Income Tax, Net Income.
Cash Flow Statement (CF)
Summarizes cash inflows and outflows over a specific period of time.
Sections:
Operating Activities: Starts with Net Income, adds back non-cash expenses (like Depreciation & Amortization, Stock-Based Compensation), and accounts for changes in Net Working Capital (NWC).
Investing Activities: Reflects cash flows from long-term investments, including Capital Expenditures (CapEx), acquisitions, or divestitures.
Financing Activities: Shows the cash impact from issuing or repurchasing debt/equity, and dividends paid to shareholders.
Balance Sheet (BS)
Presents a company's financial position at a specific point in time.
Sections:
Assets:
Current Assets: Cash, Accounts Receivable, Inventory.
Noncurrent Assets: Property, Plant & Equipment (PP&E), Intangible Assets.
Liabilities:
Current Liabilities: Accounts Payable, Short-Term Debt.
Noncurrent Liabilities: Deferred Taxes, Long-Term Debt, Lease Obligations.
Shareholder Equity (SE): Common Stock, Additional Paid-in Capital, Preferred Stock, Treasury Stock, Retained Earnings.
How the Three Statements Link Together
Income Statement: Revenue and expenses lead to Net Income.
Cash Flow Statement: Starts with Net Income, makes cash inflow/outflow adjustments (non-cash items, NWC changes, investing/financing activities), and ends with the Net Change in Cash.
Balance Sheet: The Net Change in Cash from the CF statement is reflected in the Cash account on the Asset side of the BS. Net Income from the IS flows into Retained Earnings (part of SE) on the BS. Changes in Assets/Liabilities over the period are reflected as Working Capital changes in the CF statement.
Transaction Walk-through Examples:
CapEx (Capital Expenditure) of 100$: Initially (Year 0):
IS: No effect.
CF: -$100$ from investing activities (cash outflow), net change is -$100$.
BS: Cash (Asset) down 100, PP&E (Asset) up 100. (Balances)
Depreciation of 5 (with 20% tax rate): In subsequent years (Year 1):
IS: Pre-tax income down 5, Net Income down 5 imes (1-0.20) = 4.
CF: Net Income down 4 (from IS), add back Depreciation of 5 (non-cash), net change is up 1. (Operating activities)
BS: Cash (Asset) up 1, PP&E (Asset) down 5 (accumulated depreciation), Retained Earnings / Net Income (Equity) down 4. (Balances: +1 - 5 = -4 on Assets, -4 on Equity)
100 Debt Issuance: (Assuming for investing, e.g., to buy factories)
IS: No effect (initial debt issuance doesn't impact income).
CF: Cash inflow of 100 from financing activities, cash outflow of 100 for investing (if linked to an investment), net change in cash could be 0 or +100 depending on utilization.
BS: Cash (Asset) potentially up 100 (if not immediately spent), Debt (Liability) up 100. Or if spent on asset, PP&E (Asset) up 100, Debt (Liability) up 100. (Balances)
Interest Expense of 10 (with 40% tax rate):
IS: Pre-tax income down 10, Net Income down 10 imes (1-0.40) = 6.
CF: Net Income down 6. (No add-back for interest cash outflow itself, it's already reflected in NI.) Net change down 6.
BS: Cash (Asset) down 6, Retained Earnings / Net Income (Equity) down 6. (Balances)
Interest Expense of 10 AND Depreciation of 10 (with 40% tax rate):
IS: Pre-tax income down 10 (interest) and down 10 (depreciation), total pre-tax down 20. Net Income down 20 imes (1-0.40) = 12.
CF: Net Income down 12. Add back Depreciation of 10. Net change down 2. (Operating activities)
BS: Cash (Asset) down 2, PP&E (Asset) down 10, Retained Earnings / Net Income (Equity) down 12. (Balances: -2 - 10 = -12 on Assets, -12 on Equity)
PIK (Paid-in-Kind) Interest of 10 (with 40% tax rate):
Note: PIK interest is non-cash. It's paid by issuing more debt or equity. Assuming a liability increase.
IS: Pre-tax income down 10, Net Income down 10 imes (1-0.40) = 6.
CF: Net Income down 6. Add back PIK Interest of 10 (non-cash expense). Net change up 4. (Operating activities)
BS: Cash (Asset) up 4, Debt (Liability) up 10 (PIK interest added to principal), Retained Earnings / Net Income (Equity) down 6. (Balances: +4 on Assets, +10 - 6 = +4 on Liab+Equity)
Deferred Revenue up 10$: (Cash received, but service not yet rendered)
IS: No changes (revenue not yet recognized).
CF: Cash inflow up 10 (operating activities from change in NWC due to deferred revenue). Net change in cash up 10.
BS: Cash (Asset) up 10, Deferred Revenue (Current Liability) up 10. (Balances)
Deferred Revenue down 10$: (Service rendered, previous deferred revenue recognized)
IS: Pre-tax income up 10 (revenue recognized), Net Income up 10 imes (1-0.40) = 6 (assuming 40% tax rate).
CF: Net Income up 6. Cash outflow due to change in deferred revenue is -$10$ (this sounds contradictory in original notes, if deferred revenue decreases, it means less cash was received this period for future service, or that prior received cash is now recognized as revenue, hence a non-cash inflow. A decrease in deferred revenue liability for current period indicates cash that was previously collected is recognized as revenue, so it should be removed from the cash flow statement if starting from net income, as net income includes this revenue. So: Net Income up 6, subtract deferred revenue change -10 for a negative impact on cash flow from operations, total change in cash is down 4$$). Let's re-interpret the note: CF: