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https://www.scribd.com/doc/103800328/MerrillLynch2007AnalystValuationTraining
10/15/2015
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Summer 2007
Merrill Lynch
Investment Banking Division
Analyst Training
VALUATION OVERVIEW
Valuation Methodologies
Valuation
Methodologies
Other
Nonfinancial
parameters
Discounted
Cash Flow
Analysis
Comparable
Acquisitions
Analysis
• "Public Market
Valuation"
• Value based on market
trading multiples of
comparable companies
• "Private Market
Valuation"
• Value based on multiples
paid for comparable
companies in sale
transactions
• Includes control
premium
• DCF and its more
elaborate variations are
the most theoretically
correct way to think
about valuation and
should always be
considered
• Present value of
projected free cash flows
• Most explicitly
incorporates the future
• Enterprise value related
to nonfinancial variables
such as subscribers or
barrels of oil
• Can be used with
publiclytraded comps,
comparable acquisition
analysis, or DCF
• Liquidation analysis
• Book value
• Replacement value
• Historical trading
performance
• Breakup/sum of the
parts analysis
• LBO analysis
• Recap analysis
• Option values
PubliclyTraded
Comparable
Companies Analysis
SUMMARY VALUATION OF TARGET
Equity Valuation
Implied Multiples:
LTM EPS 8.7x  12.9x 11.7x  15.3x 10.8x  14.9x 8.8x  15.6x 9.0x  11.6x
1997 EPS 8.5  12.6 11.5  14.9 10.6  14.6 8.6  15.3 8.8 ? 11.3
1998 EPS 7.3  10.8 9.8  12.8 9.1  12.5 7.3  13.1 7.6 ? 9.7
LTM EBIT 6.2  8.6 8.0  10.0 7.4  9.8 6.3  10.2 6.4 ? 7.9
LTM EBITDA 5.0  7.0 6.5  8.1 6.1  7.9 5.1  8.3 5.2 ? 6.4
$35.75
$42.25
$41.25
$43.25
$32.00
$25.00
$24.25
$30.00
$32.50
$24.00
$15.00
$25.00
$35.00
$45.00
$55.00
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Current
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$25.63
VALUATION OVERVIEW
Practitioner’s World View
Valuation is an
art not a science
VALUATION OVERVIEW
“I guess I should warn you, if I turn out to be particularly clear, you’ve
probably misunderstood what I said.”
Alan Greenspan
“A little inaccuracy sometimes saves tons of explanations.”
H. H. Munro
“The stock is definitely undervalued. It’s worth $30 per share and it is
currently trading for $28.75.”
Comment from an equity analyst
VALUATION OVERVIEW
 Valuation is inherently imprecise. It is appropriate to think
about a range of values as opposed to a single ―correct‖ value.
 Look to the future not the past. The past is relevant only as a
guide to the future; it is often a good indicator of the future.
 Working backwards can be a valuable exercise. What do you
have to believe to justify a certain DCF value. Is it reasonable?
 Valuation is not just a numbers game. You cannot appropriately
value a business without a real understanding of the business and
its environment.
 Triangulate. Look at all your methodologies.
 Think like an investor. Don’t be afraid to use judgment. Use
common sense. Think about your ―answer.‖
Key Points to be Considered
VALUATION OVERVIEW
• Think DCF for M&A, comparables for IPOs. As a general matter,
DCF is the primary technique used in M&A with comparables used
as a confirming methodology. The reverse is true in IPOs.
• Don’t forget synergy. In the M&A world, businesses may have
different values to different buyers because of the different synergies
each may have. Synergy is the driver of M&A.
• Pay attention to markets! They are usually the best information
we have. Never forget supply and demand.
• Be consistent.
• Value and price may not be the same. Do not confuse value and
price. Value is value, price is what we have to pay. We are looking
for situations where intrinsic value and price vary.
Other Points to Keep in Mind
VALUATION OVERVIEW
Equity Value vs. Enterprise Value
In valuing a business, two measures of value are relevant:
•Equity Value
Represents value attributable to the "owners" of the company after
all debt and preferred stock obligations have been satisfied
Typically the market value of a company’s common equity (Shares
Outstanding x Current Stock Price)
•Enterprise Value (sometimes known as Firm or Transaction Value)
Represents the market value of all capital invested in a business
The value of the Total Enterprise: Market Value of Equity +
Minority Interest + Preferred Stock + Net Debt
Net Debt = ShortTerm Debt + LongTerm Debt + Capitalized
Leases  (Excess Cash and Equivalents)
VALUATION OVERVIEW
Equity Value vs. Enterprise Value – a Simplified Visual Perspective
In the world of theoretical finance, book value does not matter!!
Enterprise
Value
Market
Basis
Net Debt
Equity
Value
(Market
Value)
Other items may be includable in enterprise value, such as minority interests,
convertible securities, preferred stock, options, off balance sheet leases, and pensions.
=
Assets
Book
Basis
Liabilities
Shareholders'
Equity
(Book Value)
=
DISCOUNTED CASH FLOW ANALYSIS
“The DCF is the granddaddy of all crocks of sh.”
Rolfe and Troob, Monkey Business
DCF METHODOLOGY
 Discounted cash flow ("DCF") analysis is a method to value a business
based on the net present value of projected cash flows. These cash flows
include:
Net cash flows generated over the forecast period
A continuation or terminal value at the end of the forecast period.
 These future cash flows are discounted to the present at a discount rate
commensurate with their risk.
 DCF's are forward looking since the derived values are based on
forecasted results.
 There are three basic ways to do DCF analysis. The values generated are
equivalent provided the same underlying assumptions are used.
Overview
DCF METHODOLOGY – THREE EQUIVALENT TECHNIQUES
Technique Cash Flows Discount Rate Usage
Traditional
WACC based
approach
(discounts to
enterprise value)
Free cash
flows before
deduction of
financing
costs
WACC (using a cost of
equity determined by
CAPM and a
leveraged beta)
By far the most widely
used. Assumes capital
structure is constant
Adjusted present
value approach
(discounts to
enterprise value)
Operating
cash flows
and interest
tax shields
valued
separately
Cost of unleveraged
equity for operating
cash flows; pretax
debt cost for interest
tax shields
Used when capital
structure is expected to
vary greatly over the
forecast period
Flows to equity
approach i.e.
flows to equity
(discounts to
equity value)
Free cash
flows after
deduction of
financing
costs
Cost of equity
determined by CAPM
and a leveraged beta
Typically used in
financial services due to
the complexity in
distinguishing operating
vs. financial interest
expense
DCF METHODOLOGY: THE PROCESS
Projections Project the operating results and free cash flows of a
business over the forecast period, typically five or ten years.
Continuing or Terminal Value Estimate the terminal value of
the business using either comparable trading multiples,
acquisition multiples, and/or the perpetuity method. It is
typical for the terminal value to make up the majority of
the value in DCF analysis. Take great care here.
Discount Rate Use the weighted average cost of capital to
determine the appropriate discount rate range.
Present Value Determine a range of values for the enterprise
using a range of discount rates and projection assumptions.
Adjustments Adjust the valuation for all assets
and liabilities not accounted for in the cash flow
projections e. g. excess real estate,
unconsolidated operations, investments, other
liabilities.
Step 1
Step 2
Step 3
Step 4
Step 5
DCF METHODOLOGY – FOCUS ON THE WACCBASED DCF
 Unleveraged Cash Flow Projections: The cash flows used in this approach
differ from the cash flows in the financial statements in that they are
unleveraged; that is, they disregard the effect of capital structure. The focus is
on cash flow, not accounting net income.
 Enterprise Value: Discounting unleveraged free cash flows with the WACC
leads to enterprise value. Debt needs to be subtracted to derive equity value.
 Reasonableness of Projections: DCF results are highly sensitive to cash flows
and terminal values. Cash flow and terminal value assumptions must be
reasonable.
 Projection Horizon: The theoretically correct projection horizon is not
necessarily when growth slows and stabilizes. It is when the return on
incremental investment declines to the WACC. At this point, no matter what
the growth is, the business ceases to generate incremental value. Longer
projection horizons reduce the importance of terminal values in the analysis.
 Sensitivity Analysis: DCF valuations are based on many assumptions and it is
best to sensitize the key ones. The best variables to sensitize are sales, margins,
the WACC, and terminal value multiple and/or perpetuity growth rates.
DCF METHODOLOGY
Unleveraged Free Cash Flow
(1) Assumes that all depreciation and amortization is tax deductible. This is typically the case now that goodwill
(typically not tax deductible) is no longer subject to periodic amortization.
(2) This is probably not the same number as in the financial statements. Note the interest tax shield is being excluded
from cash flow.
(3) In a DCF you only want to include cash taxes. Look to the cash flow statement to see if the company reports any
deferred taxes.
(4) Working capital = current assets – current liabilities. However, for DCF purposes we need to adjust working
capital to exclude excess cash and equivalents from current assets and shortterm borrowings and current
maturities from current liabilities to calculate an adjusted working capital.
Unleveraged free cash flow can be derived from a business’ financial projections, even if these projections
include the effects of debt. You simply exclude interest income and interest expense and taxeffect EBIT (1).
The value of the interest tax shield is included as part of the taxeffected cost of debt in the WACC.
Start: EBIT (1)
Less: Taxes (at the marginal tax rate) (2)
Equals: TaxEffected EBIT (which also = NOPAT = EBIAT = Net income + after tax interest expense)
Plus: Depreciation and amortization (1)
Plus (Less): Increases (decreases) in deferred tax liabilities (3)
Less (Plus): Increases (decreases) in adjusted working capital (4)
Less: Capital expenditures
Equals: Unleveraged Free Cash Flow
DCF METHODOLOGY
Assumption: The business will be sold at the end of year N.
Usage: This is the most commonly used terminal value approach by
practitioners because of the difficulty in forecasting a perpetual g rate.
Exit Multiple
(1)
: The terminal value is generally determined as a multiple of
EV/EBITDA OR EV/EBIT. This value will be discounted to the present. Use
EV multiples, not P/E multiples, to be consistent with the fact that this
methodology leads to enterprise value, not equity value.
Generally the terminal multiple is derived from trading comparables. Usually
it is appropriate to take some discount from current comparable company
trading levels to reflect the fact that, all things being equal, the multiple in
future years should be less as growth slows over time. You will almost never
use a multiple higher than the company’s current multiple. Acquisition
comparables may be useful depending on the purpose of the valuation.
Continuing (Terminal) Value Calculation: Terminal Multiple Method
(1) Note that the terminal year results may be misleading if the industry is cyclical. If it is one could use a rolling average and make other
adjustments as needed.
DCF METHODOLOGY
Exit Multiple
(1)
: There is no absolutely correct answer for this but I recommend
basing your terminal multiple on trailing results. This is in contrast to what
we normally emphasize when looking at comps which is to look forward.
Rationale: The reason for this is that you typically apply the discounted version
of your multiple to the final year of the forecast, in effect looking back. To be
consistent we should use the trailing multiple from the comps for this
purpose. If for some reason the trailing multiple is not representative adjust
as appropriate.
How much of a discount: Again there are no rules. Generally I am thinking 15
20% but I can’t tell you why! It would seem logical to use even deeper
discounts for longer forecasts, again under the expectation that growth and
returns decline over time in the standard company life cycle.
Continuing (Terminal) Value Calculation: Terminal Multiple Method Continued
DCF METHODOLOGY
 Assumption: This method assumes you will own the business in perpetuity
and that the business will grow at a stable longterm rate.
 Theoretically sound: This is the most theoretically sound approach to terminal
values. Using multiples really bastardizes the valuation process by mixing in
comparables analysis.
 Perpetuity Formula: The perpetuity growth method takes the free cash flow in
the last year of the forecast period, N, and grows it one more year to year N+1.
This free cash flow is then capitalized at a rate equal to the discount rate minus
the perpetual growth rate.
Terminal Value = FCF
N
*(1+g) where FCF = free cash flow in period N
(rg) g = perpetual growth rate
r = discount rate (WACC)
Remember this is the value in year N which must then be discounted to the
present value at the WACC.
Terminal (Continuing) Value Calculation: Perpetuity Growth Method
DCF METHODOLOGY
 Normalized Cash Flow in Final Year: If the free cash flow in year N does not represent a steady state
normalized cash flow for the future, then adjustments will need to be made.
 Nominal vs. Real: Keep in mind that financial statements are usually stated in nominal terms,
including inflation. You must be aware of inflation when forecasting terminal g. For example, if your
forecast terminal g at 3% you are in effect assuming real g at zero since long term inflation in the US is
around 3%. It is okay to forecast 3% or even lower; many companies will have negative real g.
However, you need to be aware of what you are doing and explain it. Don’t be mislead by the fact
that GDP growth data is typically stated in real terms.
 Limits to g: Avoid having terminal g exceed growth in the outer years of your forecast. Remember
terminal g refers to free cash flow, not sales or earnings, although in the terminal state all of these
variables should be converging on the same g rate. Growth in excess of the 6% long term nominal
growth of the economy is generally viewed as unsustainable in perpetuity BUT remember that world
growth is higher than the US by about 2% now. Also, the average S&P 500 company gets 40% of its
revenue and 25% of its profit outside the US. This could temper the 6% limit a bit.
 Rg spread: The spread between these two variables has an enormous impact on the terminal value.
Keep in mind this formula is really a multiple. For example, if r = 10% and g = 5%, then effectively
the terminal multiple of FCF is 20 times. Low interest rates generally lead to huge terminal values.
Terminal (Continuing) Value Calculation: Perpetuity Growth Method
DCF METHODOLOGY
 The cliff: This refers to the fall off in growth often observed in DCF models. For
example, the company may be growing at 15% during the forecast period. The problem
is we can’t use terminal g that high, maybe 6% maximum. However, it seems ridiculous
to assume that a company enjoying good growth is suddenly going to start growing at 5
6% just to solve our modeling problem!
Possible solution – longer forecasting period to allow g to phase down over time
 Cap ex/depreciation relationship: These variables should be in approximate balance in
your perpetual forecast. If your perpetual g is 3% or less perhaps they can be equal and
you can assume that productivity increases and inflation net out. If your g is greater
than 3% nominal then I would suggest that cap ex should exceed depreciation by some
small amount – maybe 1020%. Again there is no science here.
 Taxes: Many companies have low cash tax rates (high deferred taxes) during the forecast
period. However, it is probably unreasonable to forecast this in perpetuity. You might
want to consider bumping the tax rate up to the marginal tax rate in perpetuity as having
material deferred taxes in perpetuity seems very unlikely.
Terminal (Continuing) Value Calculation: Perpetuity Growth Method Problem Areas
OTHER PROBLEMS WITH TERMINAL VALUES
 Forecast length: This is a particular problem for the perpetuity approach where
we need to make a perpetual growth assumption.
 Five years is often too short to capture all of the value
 The competitive advantage period, the time during which the return on capital
for incremental investments is believed to exceed the WACC, is estimated to be 12
–15 years for the stock market as a whole
Longer forecasts will certainly be ―wrong‖ but they may yield more accurate
answers than premature terminal value assumptions
Remember the time period of our valuation is perpetuity in all cases. What is
open to question is only the length of the explicit forecast period. If for
example you are afraid of adding a second five year period to your forecast
but fear the likely increase in errors involved, KEEP IN MIND THAT TO
IMPROVE THE QUALITY OF YOUR OVERALL ANSWER ALL THAT IS
REQUIRED IS THAT THE SECOND FIVE YEAR FORECAST BE MORE
ACCURATE THAN THE RESULTS OF YOUR TERMINAL GROWTH
ASSUMPTION FOR THIS PERIOD! REMEMBER THE CLIFF PROBLEM.
Terminal (Continuing) Value Calculation: More Problem Areas
OTHER PROBLEMS WITH TERMINAL VALUES
Assumptions regarding exit multiples are often checked for reasonableness by calculating
the growth rates in perpetuity that they imply (and vice versa)
To go from the exitmultiple approach to an implied perpetuity growth rate:
g = [(WACC*terminal value
n
)  FCF
n
] / [FCF
n
+ terminal value
n
]
To go from the growthinperpetuity approach to an implied exit multiple:
multiple = [FCF
n
* (1 + g)] / [EBITDA
n
* (WACC  g)]
•Note this calculation uses TV, FCF and EBITDA from the terminal year undiscounted
Multiples are a good valuation alternative BUT THEY HIDE IMPORTANT
ASSUMPTIONS. We have to break multiples down to see what they are hiding from
us. For example, there is an equivalence between the terminal multiple approach and
the terminal growth approach
OTHER PROBLEMS WITH TERMINAL VALUES
Microeconomic theory tells us that returns cannot exceed the cost of capital forever
because this state will encourage new entrants who will compete and drive returns down.
Therefore, we want to make sure that we have reasonable assumptions regarding ROIIC in
our models.
Remember g only creates value if ROIIC > WACC! If there is an equivalency than g can
be anything without changing the terminal value. I know it seems unbelievable so see
Mauboussin’s article ―Common Errors in DCF Models‖ – the algebra is in the appendix.
http://www.leggmasoncapmgmt.com/pdf/CommonErrors.pdf
IF ROIIC = WACC then according to Mauboussin this follows:
Terminal values ALSO HIDE IMPORTANT ASSUMPTIONS REGARDING
ROIIC, the return on incremental invested capital.
FCF
N+1
WACC  g
=
NOPAT
N+1
* (1 – g/ROIIC)
WACC  g
=
NOPAT
WACC
NOTE: NOPAT = EBIAT = (EBIT) * (1 – t) = Net income + after tax interest expense
OTHER PROBLEMS WITH TERMINAL VALUES
If we know what the terminal value ―is‖ from our traditional FCF perpetuity approach,
we can use these formulas to solve for ROIIC
If we have an EBITDA terminal multiple value, we can first find out what the embedded
g is and then solve for ROIIC. There will be various combos of possible gs and ROIICs.
We can try and see if we have a ROIIC problem by doing a crude calculation. We can
look at the delta in NOPAT year to year divided by the delta in investment (which equals
the change in working capital + cap ex – depreciation) from the previous year. This should
give us a crude measure of ROIIC. Alternatively we can what NOPAT/(Total Investment
approximates Net Plant plus Working Capital) is and how it is changing over time.
How can we use this information?
FCF
N+1
WACC  g
=
NOPAT
N+1
* (1 – g/ROIIC)
WACC  g
=
NOPAT
WACC
DISCOUNTED CASH FLOW ANALYSIS
Key examples of adjustments include:
Excess cash and equivalents – should be added to enterprise value via netting against
debt. We often have to guess how much cash is excess.
÷ Be sure to exclude interest income from EBITDA. Otherwise you are double
counting. You can’t include the value of excess cash and its return.
Investments – another good candidate for adding back
÷ Add values for unconsolidated subsidiaries and long term investments; subtract
minority interests. Estimate the values or use balance sheet carrying amounts as a
default guess if you have no other information.
 Be sure to exclude earnings and dividends from these items from EBITDA.
Otherwise you are double counting.
÷ These operations are not consolidated and therefore not reflected in the consolidated
cash flow forecasts
Look for other redundant and noncash producing assets not reflected in the cash flows
to add back i.e. excess real estate
÷ Money losing operations should be considered separately if possible
÷ They may have some value. Including them in the DCF analysis implicitly gives
them a negative value
Adjustments to your analysis may be required
WEIGHTED AVERAGE COST OF CAPITAL
 The weighted average cost of capital (WACC) includes an
estimate of the required rate of return for debt and equity
investors, given the uncertainty of future cash flows based on the
risk profile of the business, the industry and the company's
capital structure.
 In the M&A context, the appropriate WACC for valuation
purposes is the WACC of the target company, not the acquirer.
The target’s WACC is the best indicator of the required rate of
return for that particular investment, barring some anticipated
change in the capital structure of the target.
Overview
WEIGHTED AVERAGE COST OF CAPITAL
 Companies use a combination of debt and equity to fund their operations. The cost of capital
is the weighted average of the cost of debt and the cost of equity. This is a simplified
approach. In the real world you might have to account for items such as convertible
securities, preferred stock, and leasing.
D E
D+E D+E
E = Market Value of Equity
D = Market Value of Debt (D refers to borrowed money only NOT all liabilities)
t = Marginal Tax Rate
r
e
= Cost of Equity (from CAPM)
r
d
= Cost of Debt (assumed to be the current cost of debt
(1)
)
 Because interest expense is tax deductible, the true cost of debt is the after tax cost. The tax
rate used should be the marginal tax rate for each specific company.
 Theory calls for the market value of equity and debt to be used in the WACC. However, for
class room purposes using debt from the financial statements is adequate.
 Don’t forget there may be other layers in the capital structure like convertible debt and
preferred stock that need to be included
WACC Formula
+
r
d
x (1 – t) x r
e
x
(1) Estimate the current market cost of debt by either i) determining the average yield to maturity on existing public bonds or ii) estimating bond
rating based on credit statistics of comparable companies and referencing yields on recent offerings of comparable securities.
WACC =
WEIGHTED AVERAGE COST OF CAPITAL
 The cost of debt or required return on debt, "r
d
", is observable in the market and is best
approximated by the current yieldtomaturity on the applicable debt securities.
 Remember that the yield represents the market's expectation of future returns.
 The required return on debt will increase as the debt/capital ratio increases and
EBITDA/interest ratio decreases.
 When using the aftertax cost of debt, we are assuming that our target company is profitable
and has enough pretax profit to take full advantage of the tax deductibility of interest
expense.
 Debt is typically understood to be liabilities with an explicit interest component. ALL
LIABILITIES ARE NOT DEBT for this purpose. Unless there is some reason to suspect that
shortterm debt is seasonal or temporary, you should include it and current maturities as
part of debt. Debt should also be calculated net of excess cash. The general practice is to use
one cost of debt for all senior debt i.e. short, long, leases etc.
 The most common treatment for convertible securities in a WACC is to divide the
convertibles into their debt and warrant/option components and add each part to either debt
or equity.
 Preferred stock is not debt but a separate class of capital, a third category of capital in our
WACC illustrations. Remember regular preferred dividends are not tax deductible.
Debt Cost of Capital
WEIGHTED AVERAGE COST OF CAPITAL
 Equity investors have a residual claim on the assets (value) of a company, subordinate to that
of all classes of debt and preferred stockholders. Therefore, both the risks and expected
returns to equity holders are greater.
 The cost of equity or required return on equity (r
e
) represents an investor's expected rate of
return including dividends and capital appreciation.
 Since the cost of equity is not readily observable in the market, it is more difficult to estimate.
 Fundamentally, the cost of equity should be correlated with the perceived risk of an
investment (which generally increases with leverage).
Equity Cost of Capital
Risk
R
e
t
u
r
n
Gov’t Bonds
Food
Utilites
Pharmaceuticals
Diversified
Industrials
S&P 500
Established Technology
Newer Technology
Biotech
Venture Capital
High
Low
Low High
WEIGHTED AVERAGE COST OF CAPITAL
 The Capital Asset Pricing Model (CAPM) is a tool to estimate required equity returns.
 CAPM classifies risk into two parts: systematic risk and unsystematic risk. Unsystematic
risk is that portion of risk that can be avoided through diversification by the investor and
therefore merits no premium return.
 CAPM assumes that systematic risk is unavoidable and should be rewarded with a risk
premium, which is an expected return above the riskfree return.
The size of the risk premium is linearly proportional to the amount of risk taken.
 The formula follows
Cost of Equity = Risk free Rate + Beta(leveraged)* Market Risk Premium
NOTE: There is no PE ratio in the formula. Under CAPM, PE ratios have nothing to do
with the cost of equity
Capital Asset Pricing Model
WEIGHTED AVERAGE COST OF CAPITAL
The risk free rate is typically measured as the yield on the ten year Treasury
Note, currently the benchmark security. Some use the 30 year bond or even
treasury bills.
Market risk premium represents the expected market return minus the risk
free rate of return. The market risk premium has averaged about 7% over
time. Many observers believe the current premium is no more than 34%. The
market risk premium has proven to be surprisingly volatile over time. In
practice this is one of the most important assumptions of a DCF analysis.
Sometimes practitioners add an additional premium of 13% for small cap
companies as they are widely believed to offer greater risk and return.
÷ NOTE: This is another way of saying that larger companies, all else being
equal, are worth more. Various studies support this assertion.
Capital Asset Pricing Model
WEIGHTED AVERAGE COST OF CAPITAL
 Beta provides a method to measure the degree of an asset's systematic
(nondiversifiable) risk. The beta measures the degree to which a
company's returns vary with the return of the overall market.
 A company whose stock has a beta of 1.0 is as risky as the overall stock
market and should therefore be expected to provide market returns to
investors equal to that of the market.
 Since the cost of capital is an expected value, the beta value should be an
expected value as well. Generally, however, we use historical betas in
the classroom.
 The appropriate beta to use in the CAPM calculation is the leveraged
beta. Typically betas reported on popular websites like Yahoo are
leveraged betas. Unless otherwise specified, it is safe to assume that
betas you are given are leveraged betas.
Beta
WEIGHTED AVERAGE COST OF CAPITAL
 Use Bloomberg or other reputable source to determine the company beta. Focus
on the beta for the company you are valuing BUT It is useful check to:
a. Impute unleveraged betas from public comparables.
b. Relever the average comparables unleveraged beta based on the
company's target Debt/Capital ratio.
c. Make a judgment as to the appropriate beta for your analysis. If you have
some reason to suspect your company’s beta, adjust, or at the very least,
sensitize.
 Betas are a difficult assumption as they can vary greatly from one information
provider to another and are often at great variance with commonsense
observations about business risk. Less liquid trading markets provide
problematical data for beta calculations.
CAPM Formula
CAPM RIP?
 The cornerstone theory of modern financial market analysis is under attack.
 Key idea is that increased risks are accompanied by higher returns i.e. higher beta stocks are
riskier but have higher returns
 Recent studies show that this is NOT TRUE over the long run.
Fama and French 2004 study discredits the model
CAPM woefully under predicts the returns of low beta stocks and massively overstates
the returns of high beta stocks
Over the long run there has been essentially no relationship between beta and return
Fama and French concluded that the theory’s empirical track record was so poor that its
use in applications was probably invalid
BIG OOPS
WEIGHTED AVERAGE COST OF CAPITAL
 Assume the following:
Black Mountain Beer's Beta = 1.2
Risk Free Rate = 6.0%
Equity Risk Premium = 7.5%
 What is the cost of equity for Black Mountain Beer?
r
e
= r
f +

L
(r
m
 r
f
)
r
e
= 6.0% + 1.2 (7.5%)
r
e
= 6.0% + 9.0%
r
e
= 15.0%
An Example : Black Mountain Beer's Cost of Equity
r
D T
D E
d
×
÷
+
¸
(
¸
(
( ) 1
r
E
D E
e
×
+
¸
(
¸
(
 Black Mountain Beer ("BMB") has 8,000,000 million common shares outstanding trading at
$12.50 per share on the Asheville Exchange. BMB also has outstanding bank debt of $150
million at a 10% interest rate
(1)
.
 Black Mountain Beer has a marginal tax rate of 38%. What is BMB's weighted average cost of
capital?
WACC =
WACC = [10% x x (1  .38)] + [15% x ]
WACC = [10% x 60% x (1  .38)] + [15% x 40%]
WACC = 3.7% + 6.0%
WACC = 9.7%
WEIGHTED AVERAGE COST OF CAPITAL
An Example: Black Mountain Beer Company
+
150
250
100
250
(1) For purposes of this example, assume that 10% is also the current market cost of debt, as if Black Mountain Beer issued debt today.
Furthermore, it is better to use 10 or 15 year debt, which better approximates the cost of funding the business.
WEIGHTED AVERAGE COST OF CAPITAL
 Beta values measured in the market include the effect of leverage of the individual
companies. When estimating an appropriate beta for a specific company, you
may want to estimate the appropriate range of unlevered betas or asset betas.
 The Formula follows:

u
= 
L
/(1 + (1  T) x (Debt/Equity))
Where: 
u
= unlevered or asset beta

L
= levered beta
T = Marginal tax rate
 To relever the beta at a target capital structure:

L
= 
u
* [1 + Debt (1T)]
Equity
Delevering and Relevering Beta
WEIGHTED AVERAGE COST OF CAPITAL
An Example : BMB's Unlevered & Levered Returns
Black Mountain Beer's levered Beta was 1.2; however, that was based on a leveraged balance
sheet. What is BMB's unlevered Beta?
As shown above, without a highly leveraged balance sheet, expected returns on Black Mountain
Beer's equity are much less volatile.

u =
B
L
[1 + D (1  T)
E

u =
1.2 [1 + 150
100
(1  .38)]

u =
1.2 1.93

u = .62
WEIGHTED AVERAGE COST OF CAPITAL
 Assume Black Mountain Beer were a privately owned business and no estimate for its Beta
existed. To estimate its WACC, we could look at similar publiclytraded companies and
estimate an average unleveraged Beta for companies like Black Mountain Beer. We could
then lever this average Beta to BMB's capitalization level and calculate an implied equity
return and a WACC for BMB.
 Note that on a leveraged basis, the companies Beta's differ more due to their different capital
structures.
An Example: Estimating Beta based on Similar Companies
Comparable Companies
Levered
Beta
Debt/
Equity
Tax
Rate
Unlevered
Beta
(a)
Clingman's Dome Beer 1.45 60% 38% 1.06
Grandfather Mountain Beer 1.25 25% 40% 1.09
Average Beta 1.35 1.07
(a) Unlevered Beta = B
L
: [1+(Debt/Equity) x (1Tax Rate)].
 Assuming an unlevered Beta for Black Mountain Beer of 1.07 and given its debt to equity of
150%, we can estimate a levered Beta for BMB as follows:
 Based on this estimate we can calculate an estimated return on equity and WACC for BMB:
r
e
= r
f
+

(r
m
 r
f
)
r
e
= 6.0% + 2.07 (7.5%)
r
e
= 21.53%

L =
B
u
x (1+ Debt x (1Tax Rate)
Equity

L =
1.07 x (1+150 x (1.38)
100

L =
1.07 x 1.93

L = 2.07
WEIGHTED AVERAGE COST OF CAPITAL
An Example: Estimating Beta Based on Similar Companies (cont'd)
]
]
WACC = r
d
x (1  t) x
D
TotalCap
+ r
e
x
E
TotalCap
WACC = 10% x (.62) x
150
250
+ 21.53% x
100
250
WACC = 12.33%
DCF METHODOLOGY
Present Value Calculations
 Present Value of Cash Flow Stream: The present value takes into account the time value of
money by placing greater value on those cash flows generated earlier in the forecast period
rather than later:
Present Value = UFCF
1
+ UFCF
2
+ UFCF
3
+ + UFCF
N
(1+r)
1
(1+r)
2
(1+r)
3
(1+r)
N
 MidYear Convention: A midyear convention can also be used which assumes the cash
flows occur in the middle of the period which often better approximates the time the cash is
actually received. Discounting using a midyear convention simply requires each years
cash flow being discounted by a period of onehalf a year less
(1)
:
Present Value = UFCF
1
+ UFCF
2
+ UFCF
3
+ + UFCF
N
(1+r)
0.5
(1+r)
1.5
(1+r)
2.5
(1+r)
N.5
(1) This method will result in a higher valuation of the cash flows.
UFCF = Unlevered Free Cash Flow
r = Discount Rate
N = Period
DCF ANALYSIS – Perpetuity Method
(dollars in millions, except per share)
Assumptions:
($ millions, except per share) 2003 2004 2005 2006E 2007E 2008E 2009E 2010E Sales Growth 10.0%
Sales $400.0 $440.0 $484.0 $532.4 $585.6 $644.2 $708.6 $779.5 EBITDA Margin 20.0%
EBITDA 80.0 88.0 96.8 106.5 117.1 128.8 141.7 155.9 Increase in Depreciation 10.0%
Less: Depreciation 12.0 13.2 14.5 16.0 17.5 19.3 21.2 23.4 Marginal Tax Rate 40.0%
EBIT 68.0 74.8 82.3 90.5 99.6 109.5 120.5 132.5 CAPEX Growth 10.0%
Less: Taxes 27.2 29.9 32.9 36.2 39.8 43.8 48.2 53.0 Increase in NWC 20.0%
TaxEffected EBIT 40.8 44.9 49.4 54.3 59.7 65.7 72.3 79.5 Shares Outstanding (millions) 40.0
Plus: Depreciation 12.0 13.2 14.5 16.0 17.5 19.3 21.2 23.4
Plus (Less): Increase (Decrease) in Deferred Tax Liability 0.0 0.0 0.0 0.0 0.0
Less: CAPEX 20.0 22.0 24.2 26.6 29.3
Less (Plus): Increase (Decrease) in NWC 10.0 8.0 6.4 5.1 4.1
Free Cash Flow (FCF) $40.3 $47.3 $54.4 $61.8 $69.5
FCF Growth Rate 17.5% 15.1% 13.5% 12.5%
A + =
Discounted
Cash Flows
Discount Rate: (2006E2010E) 2.5% 3.5% 4.5% 2.5% 3.5% 4.5%
7.0% $220.1 $1,128.7 $1,465.4 $2,071.3 $1,348.8 $1,685.4 $2,291.4
7.5% 216.9 992.4 1,252.7 1,686.3 1,209.3 1,469.5 1,903.2
8.0% 213.8 881.5 1,087.9 1,412.3 1,095.3 1,301.7 1,626.0
8.5% 210.7 789.6 956.8 1,207.5 1,000.3 1,167.5 1,418.2
9.0% 207.7 712.3 850.0 1,049.0 920.0 1,057.8 1,256.7
 D + E =
Net Debt Equity
Discount Rate: a/o 12/31/05 Investments 2.5% 3.5% 4.5% 2.5% 3.5% 4.5%
7.0% $200.0 $0.0 $1,148.8 $1,485.4 $2,091.4 $28.72 $37.14 $52.28
7.5% 200.0 0.0 1,009.3 1,269.5 1,703.2 $25.23 $31.74 $42.58
8.0% 200.0 0.0 895.3 1,101.7 1,426.0 $22.38 $27.54 $35.65
8.5% 200.0 0.0 800.3 967.5 1,218.2 $20.01 $24.19 $30.46
9.0% 200.0 0.0 720.0 857.8 1,056.7 $18.00 $21.44 $26.42
Value per Share
Reference these from the balance sheet
Firm Value
PV of Terminal Value at a
Perpetual Growth Rate of [c]
F
Total Equity Value
Actual FY Ended 12/31 Projected FY Ended 12/31
B C
=((2010E FCF*(1+c))/(Discount Rate
c))/(1+Discount Rate)^5
DCF ANALYSIS: EBITDA Multiple Method
(dollars in millions, except per share)
Assumptions:
($ millions, except per share) 2003 2004 2005 2006E 2007E 2008E 2009E 2010E Sales Growth
Sales $400.0 $440.0 $484.0 $532.4 $585.6 $644.2 $708.6 $779.5 EBITDA Margin
EBITDA 80.0 88.0 96.8 106.5 117.1 128.8 141.7 155.9 Increase in Depreciation
Less: Depreciation 12.0 13.2 14.5 16.0 17.5 19.3 21.2 23.4 Marginal Tax Rate
EBIT 68.0 74.8 82.3 90.5 99.6 109.5 120.5 132.5 CAPEX Growth
Less: Taxes 27.2 29.9 32.9 36.2 39.8 43.8 48.2 53.0 Increase in NWC
TaxEffected EBIT 40.8 44.9 49.4 54.3 59.7 65.7 72.3 79.5 Shares Outstanding (millions)
Plus: Depreciation 12.0 13.2 14.5 16.0 17.5 19.3 21.2 23.4
Plus (Less): Increase (Decrease) in Deferred Tax Liability 0.0 0.0 0.0 0.0 0.0
Less: CAPEX 20.0 22.0 24.2 26.6 29.3
Less (Plus): Increase (Decrease) in NWC 10.0 8.0 6.4 5.1 4.1
Free Cash Flow (FCF) $40.3 $47.3 $54.4 $61.8 $69.5
FCF Growth Rate 17.5% 15.1% 13.5% 12.5%
A + =
Discounted
Cash Flows
Discount Rate: (2006E2010E) 13.0x 14.0x 15.0x 13.0x 14.0x 15.0x
7.0% $220.1 $1,445.0 $1,556.1 $1,667.3 $1,665.0 $1,776.2 $1,887.3
7.5% 216.9 1,411.7 1,520.3 1,628.9 1,628.6 1,737.2 1,845.7
8.0% 213.8 1,379.3 1,485.4 1,591.5 1,593.1 1,699.2 1,805.3
8.5% 210.7 1,347.8 1,451.5 1,555.2 1,558.5 1,662.2 1,765.9
9.0% 207.7 1,317.2 1,418.5 1,519.8 1,524.9 1,626.2 1,727.6
 D + E =
Net Debt Equity
Discount Rate: a/o 12/31/05 Investments 13.0x 14.0x 15.0x 13.0x 14.0x 15.0x
7.0% $200.0 $0.0 $1,465.0 $1,576.2 $1,687.3 $36.63 $39.40 $42.18
7.5% 200.0 0.0 1,428.6 1,537.2 1,645.7 $35.71 $38.43 $41.14
8.0% 200.0 0.0 1,393.1 1,499.2 1,605.3 $34.83 $37.48 $40.13
8.5% 200.0 0.0 1,358.5 1,462.2 1,565.9 $33.96 $36.56 $39.15
9.0% 200.0 0.0 1,324.9 1,426.2 1,527.6 $33.12 $35.66 $38.19
Value per Share
Reference these fromthe balance sheet
Firm Value
PV of Terminal Value as a
Multiple of 2010E EBITDA [c]
F
Total Equity Value
Actual FY Ended 12/31 Projected FY Ended 12/31
B C
=(2010E EBITDA*c)/(1+ Discount
Rate)^5
GROWTH EQUIVALENCE OF EBITDA
g = [(WACC * EBITDA TV
n
) FCF
n
]/ [FCF
n
+EBITDA TV
n
]
WACC = 8%
FCF
n
= 69.5
EBITDA TV
n
at multiple of 14.0x = 2182.6
g = 4.7% as compared to 3.5%
What Is Happening at $37.48 – the Midpoint of the Summary?
Not too bad – it can be much more out of line very easily
WHAT ABOUT ROIIC?
 This looks very suspicious here. For example, in 2008 incremental investment is
$6.4 million from working capital and $4.9 million from net cap ex, a total of $10.3
million. In 2009 NOPAT increases by $6.6 million. Life isn’t this simple, but as a
very crude measure, the ROIIC in 2009 is 6.6/10.3 = 64%! We get an even more
alarming number in 2010 – 69%. Better look deeper.
 We believe the FV of the TV in 2010 using the perpetuity method is 69.5 * 1.035 =
71.9/(.08  .035) = 1,598. Therefore, using our formula to solve for ROIIC:
1,598 = NOPAT
N+1
* (1 – g/ROIIC)
WACC – g
Solving for ROIIC yields ROIIC = 27.8%
Not as bad as I thought it might be but still way too high compared to a
WACC of 8%. If we drop the ROIIC to 8%, the FV of the TV declines to
1,028 as compared to 1,598. That in turn reduces the per share value from
$27.54 to $17.83. Basically the projection assumptions are flawed. Looking at
the EBITDA approach with the derived 4.7% g rates yields a ROIIC of 37.4%!
 Remember to insure that depending upon the free cash flows being used that you use the
appropriate discount rate:
Unleveraged cash flows Weighted Averaged Cost
of Capital
 Ensure that the projections make sense and be sure to create sensitivity tables to determine
which factors truly drive the valuation.
 Focus attention on your terminal value assumptions as they are typically by far the most
important assumptions you will make in your analysis.
 Remember DCF analysis using a WACC for the discount rate and unleveraged cash flows
leads to an enterprise value. To determine equity value, the initial period net debt (total debt
minus excess cash) needs to be deducted. DCF analysis using the cost of equity as the
discount rate and leveraged cash flows to equity leads to an equity value.
DISCOUNTED CASH FLOW ANALYSIS
Important Reminders
DISCOUNTED CASH FLOW OFTEN UNDERSTATES VALUES
Traditional DCF values expected cash flow and does not capture any
value for real options
• In the real world cash flows are contingent on the occurrence of future
events
• The ability to postpone or abandon projects or to change strategies has
potentially significant value
• The information required to properly value these options is typically
not available. Indeed the basic forecasts that are used are already
subject to a certainty of error
• Nonetheless our thinking must somehow include the value of these real
options
DISCOUNTED CASH FLOW AND OPERATING LEASES
Operating Leases
• Debt numbers on the balance sheet already include capitalized leases so
no further adjustment is necessary for them.
• Operating leases are not capitalized but lurk in the financial footnotes.
• If operating leases are material, such as for retailers, they should be
discounted at the cost of debt and the discounted amount treated as
debt. The common practitioner approach is to multiply current lease
expense by eight to estimate this capitalized amount.
• Lease expense is added to EBITDA to come up with EBITDAR
for analysis purposes (R = rent).
• Rents are treated like interest expense.
• Similar approach can be used when doing comparable company analysis.
DISCOUNTED CASH FLOW ANALYSIS
Hierarchy of Valuation Techniques
Real options and other complex valuation
techniques
Decision tree analysis
Monte Carlo simulation
Scenario DCF
Simple DCF
COMPARABLES ANALYSIS
PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS
Overview
The analysis of publiclytraded comparable companies typically consists of a
comparison of several companies’ operating and trading statistics. The exact
ratios and statistics emphasized will vary from industry to industry. Why do we
look at comparables?
• Provides a benchmark to value a company by referring to other "similar"
publiclytraded companies with "similar" operating and financial
statistics.
• Calculate valuation multiples based on current markets, industry trends
and growth.
• Provides insight into key valuation multiples for an industry.
• Serves as a value indicator for a passive, minority investment.
• Relies on the power of market based inputs.
PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS
Issues With Comparables
• WHAT IF THE COMPS ARE WRONG!!?? i.e. Yahoo is a good
comp for Google but how confident are we about Yahoo’s
valuation??
REMEMBER – comps analysis is entirely relativistic.
We are assuming that the comparable valuations are
correct.
• May not reflect an appropriate value in thinly traded, small
capitalization or underresearched stocks.
• It is extremely difficult to find truly comparable companies. The
analyst is often making judgments and compromises. In fact,
companies often strive to distinguish themselves from others.
NOTE: All companies do not have publicly traded
comparables. We may have to think outside the box.
PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS
Issues With Comparables
• The quality of the ―answers‖ is highly dependent on the quality
of the comparables and on the specific comparables chosen.
• Comparable analysis is probably more vulnerable to accounting
issues than DCF analysis.
• Comparables analysis does not focus on free cash flow and offers
only a limited look into the explicitly forecast future.
• It does not account for "control" premiums or potential synergies
realized in an acquisition.
COMPARABLE COMPANY ANALYSIS
 Comparables analysis is often a highly subjective area where nothing is
always true.
 Identifying comparables can be a major challenge. Few companies are
truly comparable with one and other.
 By far the most important thing to consider is the nature of the
underlying business. Is the industry the same? Is there a high degree of
similarity between customer types, products offered, and economic
drivers of the business?
 Size can be important. Growth can also be important. These factors are
not necessarily determinative in isolation. Margins can be important as
well. If none of these things are similar you may not have found a
comparable.
 Sometimes there are no true comparables and you may need to think out
of the box.
What Makes a Company Comparable?
PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS
Other Things to Keep in Mind
• For IPO valuations this analysis yields fully distributed value before
the IPO discount (actually this would be true as well if you were using a
DCF to value a company for an IPO. DCF is less commonly used in IPO
valuations.)
• Multiples are most useful when they look forward e.g. the current
stock price divided by forecasted EPS. The same is true of enterprise
multiples i.e. current EV/forecasted EBITDA (or EBIT or Sales.)
Generally by late spring investors are starting to look
forward another year. For example by May 2007 investors
will be starting to rely more on Current Price/2008 forecasted
EPS. By September 2007, the year 2007 no longer is that
much of a forecast and the emphasis will have shifted to
a focus on 2008.
COMPARABLE COMPANY ANALYSIS
 ENTERPRISE
VALUE/EBITDA
 ENTERPRISE VALUE/EBIT
 ENTERPRISE
VALUE/REVENUES
 ENTERPRISE
VALUE/SUBSCRIBERS OR
OTHER METRIC
 PRICE/EPS
 PE/G (―PEG Ratio‖)
 PRICE/BOOK VALUE PER
SHARE
What are the key ratios?
ENTERPRISE VALUES EQUITY VALUES
It is imperative to understand the difference between Equity Value and
Enterprise Value and their respective multiples. The difference lies in the
treatment of debt and its cost, interest expense. A multiple that has debt in the
numerator must have a statistic before interest expense in the denominator.
COMPARABLE COMPANY ANALYSIS
Things to Keep in Mind
 Enterprise ratios minimize the impact of leverage among
companies with different capital structures
 Enterprise ratios also eliminate accounting differences related to
depreciation and amortization and taxes
 Leverage influences P/E ratios in the following ways:
If EBIT/EV > cost of debt then leverage understates P/E
If EBIT/EV < cost of debt then leverage overstates P/E
If a company has a high P/E ratio it may be ―cheaper‖ from an
EPS dilution notion of the cost of equity to sell stock than to
issue debt, exactly the opposite of the real economic situation
COMPARABLE COMPANY ANALYSIS
 All of them! They are easy to calculate and you might learn something.
 Emphasize PEs, EV/EBITDA, EV/EBIT, and PEG ratios. Focus on
forward ratios.
Try and understand why PEs and enterprise ratios give a different
answer, if in fact they do.
EBIT is generally a better measure than EBITDA but EBITDA is more
commonly used. Look at both to be safe.
÷ Remember neither EBITDA nor EBIT represents free cash flow.
÷ For many companies, capital expenditures > depreciation.
Therefore, some prefer EBIT as a better proxy for free cash flow.
÷ On the other hand using EBIT does not help minimize the impact
of depreciation and amortization differences.
 EV/Revenues is possibly okay depending on circumstances. The key
problem is that it ignores profitability. This is typically used for young
companies without profits or even EBITDA.
Which Ratios Should You Use?
COMPARABLE COMPANY ANALYSIS
 PEG ratios are commonly used, especially with growth companies.
PEG ratios are typically calculated as forward PE/five year or secular growth
rate * 100.
Slower growth companies often have higher PEGs, perhaps because g is more
predictable for them.
The concept is what price in terms of PE ratio is an investor paying for a
percentage of growth rate.
Remember, like everything else in the world of comps, this is a relativistic
concept. A PEG ratio of less than one does not mean the stock is necessarily
cheap. The PEG for the S&P 500 is about 1.8x.
Focus on the comps when thinking about this.
PEG ratios have a dubious intellectual validity but are widely used. Note that
if the company has zero g it has no value! Ridiculous!
 Price/book is the most dubious of all ratios. It may have more validity when
looking at financial services companies. Deemphasize this ratio as a general
matter.
PEG Ratios and Price/Book
PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS
 Once you have calculated relevant multiples for each comparable company, you
must then determine which multiples or range of multiples justify a reasonable
benchmark for valuation of the specific target.
 Analyze results and decide which companies are most comparable.
Exclude outlying multiples; use common sense.
Don’t make the universe of truly comparable companies greater at the expense
of diluting the quality of the information that you have. It is better to focus on
one or two really good comps then six or eight sort of comparable companies.
This doesn’t mean that you want to completely ignore ―sort of‖ comps.
 Look at mean and median multiples, high and low multiples and multiples of
specific companies which may be particularly relevant and comparable.
Don’t allow yourself to become overly focused on means and medians.
These can hide lots of useful information.
 Use judgment to determine which multiples are most relevant (Net Income, EBIT,
EBITDA, Sales, etc.) given the company and the nature of its business.
Deriving Valuations
TRADING MULTIPLES VS. DCF
 Easy to use
 No terminal value estimate to
worry about
 Captures information provided by
an efficient market
 Good crosscheck for DCF
 Captures explicit outlook for the
business being evaluated
 Driven by cash flow, not
accounting earnings
 Theoretically correct
 Pure comparables rarely exist
 Potentially distorted by accounting
 Not focused on cash flow
 Disguises lots of assumptions made
by the market
 Are the relative valuations believable?
 Limited explicit focus on the future
 Time consuming and complex
 Highly sensitive to cost of capital and
terminal value assumptions
 Wide range of forecasts possible
PROS CONS
Trading
Multiples
DCF
Pros and Cons
COMPARABLE ACQUISITION TRANSACTIONS
The comparable acquisition transactions analysis contains information about
selected acquisition transactions in the same industry as the company being
evaluated. The purpose is similar to that of public comparables analysis except
that by looking at prior acquisitions, insight can be gained for the premium paid
to gain control (i.e., control premium) of the target company.
Typically even more difficult to find true comparables
When preparing "acquisition comps", consider the following:
 Time frame is typically five years. This greatly complicates things as
valuation parameters like interest rates and stock market values can vary
greatly over time.
 Status of deal – Completed? Pending? Withdrawn?
 Consideration: Cash vs. Stock
 Hostile vs. Friendly
Overview
COMPARABLE ACQUISITION TRANSACTIONS
 Measures Private Market Value ("Control Value")
 However, does not directly deal with the value of synergies, the primary
economic driver of M&A activity.
 Develop Understanding of M&A Activity in Industry
a. Relative Activity
b. Who is buying?
c. What they are buying (market share, technology, etc.)?
d. How much are buyers paying?
DO NOT RELY ON ACQUISITION COMPARABLES UNLESS
YOU ARE VALUING A COMPANY FOR THAT PURPOSE
Objectives of Comparisons of Acquisition Transactions
COMPARABLE ACQUISITION TRANSACTIONS
 Number of buyers
 Synergies – these vary from company to company
 Availability of alternative targets
 Competition among investors
 DCF values
 Comparables
 Nonprice issues – i.e. governance
 Transaction structure
 Tax, accounting, and legal issues
Many Factors Influence Price
APPENDIX
DISCOUNTED CASH FLOW ANALYSIS  SYNERGIES
There are two general approaches to valuing synergies in mergers and acquisitions.
Analyze the forecast for the target with and without the transaction. The difference can
be seen as synergies
More commonly we analyze the synergies themselves – the additional cash flow
anticipated to be created as a result of the mergers. These are typcially broken into two
components – revenue synergies and cost synergies. Other common synergies include
working capital and capital expenditure savings.
÷ Typically we look at a three to five year forecast
÷ Tax effect the cost savings and similarly make sure you are dealing with after tax
cash flow, not revenues, as relates to the revenue synergies. You may need to reduce
revenue estimates to operating income to after tax cash flow.
÷ Allow for any incremental investments that may be required to produce the
synergies
÷ Assign a terminal value based on the perpetuity growth formula
÷ Discount to present value using the target’s WACC or cost of equity
COMPANIES WITH MULTIPLE BUSINESS LINES ARE OFTEN
VALUED ON A SUM OF OF THE PARTS BASIS
This approach is sometimes referredto as a ―breakup‖ valuation.
– Particularly common when the parts have different financial
and growth characteristics.
– Highlights the market discount for diversified companies.
The methodology requires estimating financial results for each
business (EBIT, EBITDA and/or net income), which can then be used
with appropriate multiples or growth rates in order to arrive at a value
for each part. If sufficient information is available, DCF analysis may
also be used for the some or all of the parts.
Completing a sumoftheparts valuation is more challenging than a
straightforward (singlebusiness/consolidated) comparable or DCF
analysis.
–Typically less detailed financial data is publiclyavailable for
segments.
–Often assumptions must be made about how to allocate
expenses, especially those that are clearly shared across businesses
(like corporatelevel SG&A.)
–The different characteristics of each business segment (betas,
terminal value assumptions, etc.) must be considered.
THE ROLE OF P/E RATIOS AND INTEREST PAYMENTS IN EPS
DILUTION AND ACCRETION ANALYSIS
For stockforstock deals, accretion or dilution potential will usually be evident by simply
comparing the P/E multiples of the acquirer and the target
–If the acquirer has a higher P/E than the target, the deal will be accretive because the acquirer
is buying more EPS than the target shareholders are accepting as consideration
–If the acquirer has a lower P/E than the target, the deal will be dilutive because the acquirer is
buying less EPS than the target shareholders are accepting as consideration
–Remember to take the premium into account when calculating the target’s P/E
–Utility of comparison will also depend on transaction assumptions regarding goodwill
impairment or other asset amortization
For 100% cash transactions, the cost of debt (interest payments) and cost of acquiring the target’s
earnings will determine the accretive or dilutive impact of a transaction
–Where the inverse cost of debt (1/(aftertax cost of debt)) is greater than the P/E of the target,
the deal will be accretive
–Where the inverse cost of debt is lower than the P/E of the target, the deal will be dilutive
DEALING WITH MINORITY INTERESTS AND EQUITY IN
UNCONSOLIDATED AFFILIATES
Minority interest
Equity interest
Minority interest represents the portion of a
consolidated subsidiary which you do not own
Need to make sure the numerator and denominator
of a trading multiple are on an applestoapples basis
–Numerator: Add the minority interest
(market value if available or book value) to
firm value
–Denominator: Consolidated financial results
Consider the following example:
–Market cap of $500MM
–Debt of $500MM
–Consolidated EBITDA of $100MM
–Minority interest of $50MM
Firm Value = $1050, EBITDA = $100
–FV / EBITDA = 10.5x
Equity interest in unconsolidated affiliates
represents a minority stake you hold in another
company
Need to make sure the numerator and
denominator of a trading multiple are on an
applestoapples basis
–Numerator: Subtract the equity interest
(market value if available or book value)
from firm value (i.e. treat as cash)
–Denominator: Consolidated financial
results (do not include equity interest)
Consider the following example:
–Market cap of $500MM
–Debt of $500MM
–Consolidated EBITDA of $100MM
–Equity interest of $50MM
Firm Value = $950, EBITDA = $100
–FV / EBITDA = 9.5x
PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS
1. Multiply operating results of company to be valued by relevant comparable company
multiples.
÷ LTM results (LTM = latest twelve months)
÷ Projected fiscal year results
÷ Select relevant multiple range
2. Convert derived Equity Values to Enterprise Values by adding Net Debt.
÷ Net Income/EPS estimates multiples
÷ Book Value multiples
3. Convert derived Enterprise Values to Equity Values by subtracting Net Debt.
÷ Sales multiples
÷ EBITDA multiples
÷ EBIT multiples
4. Per Share Values can be obtained by dividing Equity Values by shares outstanding. For an
M&A analysis, Net Debt should be adjusted for convertible securities and option/warrant
proceeds, and diluted shares outstanding should be used.
Imputing Values – Things to Remember
PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS
Imputing Values – Formulas
Implied Values
EPS — Target EPS x Relevant multiple from set of comparables
Net Income —(Comparable Net Income multiple x Target Net Income)
Target Shares Outstanding
EBIT — ((Comparable EBIT multiple x Target EBIT) – Target Net Debt)
Target Shares Outstanding
EBITDA — ((Comparable EBITDA multiple x Target EBITDA) – Target Net Debt)
Target Shares Outstanding
Sales — ((Comparable Sales multiple x Target sales) – Target Net Debt)
Target Shares Outstanding
Financial
Result
Mean Multiple of
Public Comparables
Dec97 EPS: $2.83 9.3x
Dec98 EPS: $3.31 8.7x
LTM EBITDA: $87.0 mm 6.2x
LTM EBIT: $70.7 mm 8.0x
Net Debt: $88.0 mm
Diluted Shares Outstanding: 14.6 mm
What is the implied equity per share value of Rookie Enterprises on a Dec98 EPS basis?
Dec98 EPS: $3.31
x Mean Multiple: $8.7x
= Implied Equity Per Share Value $28.80
What is the implied equity per share value of Rookie Enterprises on an LTM EBITDA?
LTM EBITDA $87.0
x Mean Multiple: 6.2x
= Implied Market Capitalization $539.4
 Net Debt ($88.0)
= Implied Market Value $451.4
/ Diluted Shares Outstanding 14.6
= Implied Equity Per Share Value $30.92
PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS
Assume Rookie Enterprises has the following financial information:
Imputing Values – An Example Using Means and Medians
PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS
Imputing Multiples
 After determining a range of values under different methodologies, such as DCF, implied multiples
should be calculated.
 Implies relevant range of valuation multiples (i.e., how much should someone pay for the target).
 Formulas:
EPS — Imputed Value Per Share
Target EPS
EBIT — (Imputed Value Per Share x Target Shares Outstanding + Target Net Debt)
Target EBIT
EBITDA — (Imputed Value Per Share x Target Shares Outstanding + Target Net Debt)
Target EBITDA
Sales — (Imputed Value Per Share x Target Shares Outstanding + Target Net Debt)
Target Sales
PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS
Imputing Multiples – An Example Using Highs and Lows
Financial
Result
Mean Multiple of
Public Comparables
Dec97 EPS: $2.83 9.3x
Dec98 EPS: $3.31 8.7x
LTM EBITDA: $87.0 mm 6.2x
LTM EBIT: $70.7 mm 8.0x
Net Debt: $88.0 mm
Diluted Shares Outstanding: 14.6 mm
What is the implied 1997 EPS multiple if the low end of the Acquisition Comparables valuation range is $32.50?
Equity Per Share Valuation $32.50 per share
/ 1997 EPS $2.83
= Implied 1997 EPS Multiple 11.5x
What is the implied LTM EBITDA multiple if the high end of the Public Comparables valuation range is $35.75?
Equity Per Share Valuation $35.75 per share
x Diluted Shares Outstanding: 14.6
= Implied Market Value $522.0
+ Net Debt $88.0
= Implied Market Capitalization $610.0
/ LTM EBITDA $87.0
= Implied LTM EBITDA Multiple 7.0x
Recall Rookie Enterprises has the following financial information:
VALUATION OVERVIEW Valuation Methodologies
Valuation Methodologies
PubliclyTraded Comparable Companies Analysis
• "Public Market Valuation" • Value based on market trading multiples of comparable companies
Comparable Acquisitions Analysis
• "Private Market Valuation" • Value based on multiples paid for comparable companies in sale transactions • Includes control premium
Discounted Cash Flow Analysis
• DCF and its more elaborate variations are the most theoretically correct way to think about valuation and should always be considered • Present value of projected free cash flows • Most explicitly incorporates the future
Nonfinancial parameters
Other
• Enterprise value related to nonfinancial variables such as subscribers or barrels of oil • Can be used with publiclytraded comps, comparable acquisition analysis, or DCF
• Liquidation analysis • Book value • Replacement value • Historical trading performance • Breakup/sum of the parts analysis • LBO analysis • Recap analysis • Option values
SUMMARY VALUATION OF TARGET Equity Valuation
Equity Value Per Share
$55.00 $45.00 $35.00 $25.00 $15.00 $35.75 $32.50 $24.00 $30.00 $24.25 $25.00
Current Price $25.63
$42.25
$41.25
$43.25 $32.00
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Implied Multiples: LTM EPS 1997 EPS 1998 EPS LTM EBIT LTM EBITDA 8.7x  12.9x 8.5  12.6 7.3  10.8 6.2  8.6 5.0  7.0 11.7x  15.3x 11.5  14.9 9.8  12.8 8.0  10.0 6.5  8.1 10.8x  14.9x 10.6  14.6 9.1  12.5 7.4  9.8 6.1  7.9 8.8x  15.6x 8.6  15.3 7.3  13.1 6.3  10.2 5.1  8.3 9.0x  11.6x 8.8 ? 11.3 7.6 ? 9.7 6.4 ? 7.9 5.2 ? 6.4
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VALUATION OVERVIEW Practitioner’s World View Valuation is an art not a science .
VALUATION OVERVIEW “I guess I should warn you.” H. It’s worth $30 per share and it is currently trading for $28. Munro “The stock is definitely undervalued. you’ve probably misunderstood what I said.” Alan Greenspan “A little inaccuracy sometimes saves tons of explanations.75. if I turn out to be particularly clear.” Comment from an equity analyst . H.
Look to the future not the past. Think about your ―answer. Valuation is not just a numbers game. Working backwards can be a valuable exercise. Is it reasonable? You cannot appropriately value a business without a real understanding of the business and its environment. Don’t be afraid to use judgment.‖ . Look at all your methodologies. Think like an investor. The past is relevant only as a guide to the future. It is appropriate to think about a range of values as opposed to a single ―correct‖ value. Use common sense. it is often a good indicator of the future.VALUATION OVERVIEW Key Points to be Considered Valuation is inherently imprecise. What do you have to believe to justify a certain DCF value. Triangulate.
businesses may have different values to different buyers because of the different synergies each may have. Do not confuse value and price. . • Be consistent. We are looking for situations where intrinsic value and price vary. The reverse is true in IPOs. In the M&A world. As a general matter. Never forget supply and demand. • Value and price may not be the same. • Don’t forget synergy. Synergy is the driver of M&A. • Pay attention to markets! They are usually the best information we have. DCF is the primary technique used in M&A with comparables used as a confirming methodology.VALUATION OVERVIEW Other Points to Keep in Mind • Think DCF for M&A. price is what we have to pay. Value is value. comparables for IPOs.
(Excess Cash and Equivalents) . Enterprise Value In valuing a business.VALUATION OVERVIEW Equity Value vs. two measures of value are relevant: •Equity Value Represents value attributable to the "owners" of the company after all debt and preferred stock obligations have been satisfied Typically the market value of a company’s common equity (Shares Outstanding x Current Stock Price) •Enterprise Value (sometimes known as Firm or Transaction Value) Represents the market value of all capital invested in a business The value of the Total Enterprise: Market Value of Equity + Minority Interest + Preferred Stock + Net Debt Net Debt = ShortTerm Debt + LongTerm Debt + Capitalized Leases .
options. book value does not matter!! Market Basis Book Basis Net Debt Enterprise Value = Liabilities Assets = Equity Value (Market Value) Shareholders' Equity (Book Value) Other items may be includable in enterprise value. such as minority interests.VALUATION OVERVIEW Equity Value vs. . and pensions. Enterprise Value – a Simplified Visual Perspective In the world of theoretical finance. convertible securities. preferred stock. off balance sheet leases.
” Rolfe and Troob. Monkey Business .DISCOUNTED CASH FLOW ANALYSIS “The DCF is the granddaddy of all crocks of sh.
These future cash flows are discounted to the present at a discount rate commensurate with their risk.DCF METHODOLOGY Overview Discounted cash flow ("DCF") analysis is a method to value a business based on the net present value of projected cash flows. The values generated are equivalent provided the same underlying assumptions are used. There are three basic ways to do DCF analysis. These cash flows include: Net cash flows generated over the forecast period A continuation or terminal value at the end of the forecast period. DCF's are forward looking since the derived values are based on forecasted results. .
Assumes capital CAPM and a structure is constant leveraged beta) Cost of unleveraged equity for operating cash flows. flows to equity (discounts to equity value) Typically used in financial services due to the complexity in distinguishing operating vs.e.DCF METHODOLOGY – THREE EQUIVALENT TECHNIQUES Technique Traditional WACC based approach (discounts to enterprise value) Adjusted present value approach (discounts to enterprise value) Cash Flows Discount Rate Free cash flows before deduction of financing costs Operating cash flows and interest tax shields valued separately Free cash flows after deduction of financing costs Usage WACC (using a cost of By far the most widely equity determined by used. pretax debt cost for interest tax shields Cost of equity determined by CAPM and a leveraged beta Used when capital structure is expected to vary greatly over the forecast period Flows to equity approach i. financial interest expense .
Discount Rate Use the weighted average cost of capital to determine the appropriate discount rate range. acquisition multiples. g. other liabilities. unconsolidated operations. Continuing or Terminal Value Estimate the terminal value of the business using either comparable trading multiples. typically five or ten years. Present Value Determine a range of values for the enterprise using a range of discount rates and projection assumptions.DCF METHODOLOGY: THE PROCESS Projections Project the operating results and free cash flows of a business over the forecast period. investments. Step 1 Step 2 Step 3 Step 4 Step 5 . excess real estate. and/or the perpetuity method. Adjustments Adjust the valuation for all assets and liabilities not accounted for in the cash flow projections e. It is typical for the terminal value to make up the majority of the value in DCF analysis. Take great care here.
Debt needs to be subtracted to derive equity value. At this point. the WACC. Cash flow and terminal value assumptions must be reasonable. they disregard the effect of capital structure. Reasonableness of Projections: DCF results are highly sensitive to cash flows and terminal values. no matter what the growth is. Sensitivity Analysis: DCF valuations are based on many assumptions and it is best to sensitize the key ones. . the business ceases to generate incremental value. not accounting net income. Enterprise Value: Discounting unleveraged free cash flows with the WACC leads to enterprise value. margins.DCF METHODOLOGY – FOCUS ON THE WACCBASED DCF Unleveraged Cash Flow Projections: The cash flows used in this approach differ from the cash flows in the financial statements in that they are unleveraged. Projection Horizon: The theoretically correct projection horizon is not necessarily when growth slows and stabilizes. It is when the return on incremental investment declines to the WACC. that is. The best variables to sensitize are sales. The focus is on cash flow. Longer projection horizons reduce the importance of terminal values in the analysis. and terminal value multiple and/or perpetuity growth rates.
This is probably not the same number as in the financial statements. Look to the cash flow statement to see if the company reports any deferred taxes. This is typically the case now that goodwill (typically not tax deductible) is no longer subject to periodic amortization. However. You simply exclude interest income and interest expense and taxeffect EBIT (1). . for DCF purposes we need to adjust working capital to exclude excess cash and equivalents from current assets and shortterm borrowings and current maturities from current liabilities to calculate an adjusted working capital. even if these projections include the effects of debt. In a DCF you only want to include cash taxes. The value of the interest tax shield is included as part of the taxeffected cost of debt in the WACC. Working capital = current assets – current liabilities.DCF METHODOLOGY Unleveraged Free Cash Flow Unleveraged free cash flow can be derived from a business’ financial projections. Start: EBIT (1) Less: Taxes (at the marginal tax rate) (2) Equals: TaxEffected EBIT (which also = NOPAT = EBIAT = Net income + after tax interest expense) Plus: Depreciation and amortization (1) Plus (Less): Increases (decreases) in deferred tax liabilities (3) Less (Plus): Increases (decreases) in adjusted working capital (4) Less: Capital expenditures Equals: Unleveraged Free Cash Flow (1) (2) (3) (4) Assumes that all depreciation and amortization is tax deductible. Note the interest tax shield is being excluded from cash flow.
. (1) Note that the terminal year results may be misleading if the industry is cyclical. This value will be discounted to the present. Exit Multiple (1): The terminal value is generally determined as a multiple of EV/EBITDA OR EV/EBIT. Generally the terminal multiple is derived from trading comparables. Usage: This is the most commonly used terminal value approach by practitioners because of the difficulty in forecasting a perpetual g rate. the multiple in future years should be less as growth slows over time. If it is one could use a rolling average and make other adjustments as needed. Use EV multiples. all things being equal. not P/E multiples. Acquisition comparables may be useful depending on the purpose of the valuation. You will almost never use a multiple higher than the company’s current multiple.DCF METHODOLOGY Continuing (Terminal) Value Calculation: Terminal Multiple Method Assumption: The business will be sold at the end of year N. Usually it is appropriate to take some discount from current comparable company trading levels to reflect the fact that. to be consistent with the fact that this methodology leads to enterprise value. not equity value.
again under the expectation that growth and returns decline over time in the standard company life cycle. Rationale: The reason for this is that you typically apply the discounted version of your multiple to the final year of the forecast. Generally I am thinking 1520% but I can’t tell you why! It would seem logical to use even deeper discounts for longer forecasts. This is in contrast to what we normally emphasize when looking at comps which is to look forward. in effect looking back. How much of a discount: Again there are no rules. . To be consistent we should use the trailing multiple from the comps for this purpose.DCF METHODOLOGY Continuing (Terminal) Value Calculation: Terminal Multiple Method Continued Exit Multiple (1): There is no absolutely correct answer for this but I recommend basing your terminal multiple on trailing results. If for some reason the trailing multiple is not representative adjust as appropriate.
Perpetuity Formula: The perpetuity growth method takes the free cash flow in the last year of the forecast period.DCF METHODOLOGY Terminal (Continuing) Value Calculation: Perpetuity Growth Method Assumption: This method assumes you will own the business in perpetuity and that the business will grow at a stable longterm rate. Using multiples really bastardizes the valuation process by mixing in comparables analysis. . N. and grows it one more year to year N+1. This free cash flow is then capitalized at a rate equal to the discount rate minus the perpetual growth rate. Theoretically sound: This is the most theoretically sound approach to terminal values. Terminal Value = FCFN*(1+g) (rg) where FCF = free cash flow in period N g = perpetual growth rate r = discount rate (WACC) Remember this is the value in year N which must then be discounted to the present value at the WACC.
then effectively the terminal multiple of FCF is 20 times.DCF METHODOLOGY Terminal (Continuing) Value Calculation: Perpetuity Growth Method Normalized Cash Flow in Final Year: If the free cash flow in year N does not represent a steady state normalized cash flow for the future. You must be aware of inflation when forecasting terminal g. the average S&P 500 company gets 40% of its revenue and 25% of its profit outside the US. This could temper the 6% limit a bit. For example. if r = 10% and g = 5%. including inflation. For example. However. then adjustments will need to be made. Keep in mind this formula is really a multiple. Don’t be mislead by the fact that GDP growth data is typically stated in real terms. many companies will have negative real g. Low interest rates generally lead to huge terminal values. Nominal vs. Rg spread: The spread between these two variables has an enormous impact on the terminal value. . if your forecast terminal g at 3% you are in effect assuming real g at zero since long term inflation in the US is around 3%. It is okay to forecast 3% or even lower. Also. you need to be aware of what you are doing and explain it. Real: Keep in mind that financial statements are usually stated in nominal terms. Growth in excess of the 6% long term nominal growth of the economy is generally viewed as unsustainable in perpetuity BUT remember that world growth is higher than the US by about 2% now. not sales or earnings. Limits to g: Avoid having terminal g exceed growth in the outer years of your forecast. Remember terminal g refers to free cash flow. although in the terminal state all of these variables should be converging on the same g rate.
the company may be growing at 15% during the forecast period. The problem is we can’t use terminal g that high. For example. If your g is greater than 3% nominal then I would suggest that cap ex should exceed depreciation by some small amount – maybe 1020%. However. You might want to consider bumping the tax rate up to the marginal tax rate in perpetuity as having material deferred taxes in perpetuity seems very unlikely. Again there is no science here.DCF METHODOLOGY Terminal (Continuing) Value Calculation: Perpetuity Growth Method Problem Areas The cliff: This refers to the fall off in growth often observed in DCF models. it is probably unreasonable to forecast this in perpetuity. If your perpetual g is 3% or less perhaps they can be equal and you can assume that productivity increases and inflation net out. Taxes: Many companies have low cash tax rates (high deferred taxes) during the forecast period. . However. it seems ridiculous to assume that a company enjoying good growth is suddenly going to start growing at 56% just to solve our modeling problem! Possible solution – longer forecasting period to allow g to phase down over time Cap ex/depreciation relationship: These variables should be in approximate balance in your perpetual forecast. maybe 6% maximum.
the time during which the return on capital for incremental investments is believed to exceed the WACC. . If for example you are afraid of adding a second five year period to your forecast but fear the likely increase in errors involved. is estimated to be 12 –15 years for the stock market as a whole Longer forecasts will certainly be ―wrong‖ but they may yield more accurate answers than premature terminal value assumptions Remember the time period of our valuation is perpetuity in all cases. What is open to question is only the length of the explicit forecast period. KEEP IN MIND THAT TO IMPROVE THE QUALITY OF YOUR OVERALL ANSWER ALL THAT IS REQUIRED IS THAT THE SECOND FIVE YEAR FORECAST BE MORE ACCURATE THAN THE RESULTS OF YOUR TERMINAL GROWTH ASSUMPTION FOR THIS PERIOD! REMEMBER THE CLIFF PROBLEM. Five years is often too short to capture all of the value The competitive advantage period.OTHER PROBLEMS WITH TERMINAL VALUES Terminal (Continuing) Value Calculation: More Problem Areas Forecast length: This is a particular problem for the perpetuity approach where we need to make a perpetual growth assumption.
FCFn] / [FCFn + terminal valuen] To go from the growthinperpetuity approach to an implied exit multiple: multiple = [FCFn * (1 + g)] / [EBITDAn * (WACC . We have to break multiples down to see what they are hiding from us. For example. there is an equivalence between the terminal multiple approach and the terminal growth approach Assumptions regarding exit multiples are often checked for reasonableness by calculating the growth rates in perpetuity that they imply (and vice versa) To go from the exitmultiple approach to an implied perpetuity growth rate: g = [(WACC*terminal valuen) .OTHER PROBLEMS WITH TERMINAL VALUES Multiples are a good valuation alternative BUT THEY HIDE IMPORTANT ASSUMPTIONS. FCF and EBITDA from the terminal year undiscounted .g)] •Note this calculation uses TV.
Therefore. we want to make sure that we have reasonable assumptions regarding ROIIC in our models.g = NOPAT WACC NOTE: NOPAT = EBIAT = (EBIT) * (1 – t) = Net income + after tax interest expense .leggmasoncapmgmt.g NOPATN+1 * (1 – g/ROIIC) WACC . I know it seems unbelievable so see Mauboussin’s article ―Common Errors in DCF Models‖ – the algebra is in the appendix. the return on incremental invested capital.pdf IF ROIIC = WACC then according to Mauboussin this follows: = FCFN+1 WACC .OTHER PROBLEMS WITH TERMINAL VALUES Terminal values ALSO HIDE IMPORTANT ASSUMPTIONS REGARDING ROIIC.com/pdf/CommonErrors. http://www. Microeconomic theory tells us that returns cannot exceed the cost of capital forever because this state will encourage new entrants who will compete and drive returns down. Remember g only creates value if ROIIC > WACC! If there is an equivalency than g can be anything without changing the terminal value.
We can try and see if we have a ROIIC problem by doing a crude calculation. we can first find out what the embedded g is and then solve for ROIIC. Alternatively we can what NOPAT/(Total Investment approximates Net Plant plus Working Capital) is and how it is changing over time. There will be various combos of possible gs and ROIICs.g = NOPAT WACC . This should give us a crude measure of ROIIC.OTHER PROBLEMS WITH TERMINAL VALUES How can we use this information? If we know what the terminal value ―is‖ from our traditional FCF perpetuity approach. We can look at the delta in NOPAT year to year divided by the delta in investment (which equals the change in working capital + cap ex – depreciation) from the previous year. we can use these formulas to solve for ROIIC If we have an EBITDA terminal multiple value.g = NOPATN+1 * (1 – g/ROIIC) WACC . FCFN+1 WACC .
Otherwise you are double counting. You can’t include the value of excess cash and its return. Otherwise you are double counting. Including them in the DCF analysis implicitly gives them a negative value . subtract minority interests. These operations are not consolidated and therefore not reflected in the consolidated cash flow forecasts Look for other redundant and noncash producing assets not reflected in the cash flows to add back i. We often have to guess how much cash is excess. excess real estate Money losing operations should be considered separately if possible They may have some value. Be sure to exclude earnings and dividends from these items from EBITDA.e. Investments – another good candidate for adding back Add values for unconsolidated subsidiaries and long term investments.DISCOUNTED CASH FLOW ANALYSIS Adjustments to your analysis may be required Key examples of adjustments include: Excess cash and equivalents – should be added to enterprise value via netting against debt. Be sure to exclude interest income from EBITDA. Estimate the values or use balance sheet carrying amounts as a default guess if you have no other information.
The target’s WACC is the best indicator of the required rate of return for that particular investment. purposes is the WACC of the target company.WEIGHTED AVERAGE COST OF CAPITAL Overview The weighted average cost of capital (WACC) includes an estimate of the required rate of return for debt and equity investors. In the M&A context. not the acquirer. given the uncertainty of future cash flows based on the risk profile of the business. the industry and the company's capital structure. the appropriate WACC for valuation . barring some anticipated change in the capital structure of the target.
In the real world you might have to account for items such as convertible securities. The tax rate used should be the marginal tax rate for each specific company. for class room purposes using debt from the financial statements is adequate. the true cost of debt is the after tax cost. The cost of capital is the weighted average of the cost of debt and the cost of equity. WACC = rd x (1 – t) x D D+E + re x E D+E E = Market Value of Equity D = Market Value of Debt (D refers to borrowed money only NOT all liabilities) t = Marginal Tax Rate re = Cost of Equity (from CAPM) rd = Cost of Debt (assumed to be the current cost of debt(1)) Because interest expense is tax deductible. preferred stock. However. . This is a simplified approach. and leasing. Theory calls for the market value of equity and debt to be used in the WACC.WEIGHTED AVERAGE COST OF CAPITAL WACC Formula Companies use a combination of debt and equity to fund their operations. Don’t forget there may be other layers in the capital structure like convertible debt and preferred stock that need to be included (1) Estimate the current market cost of debt by either i) determining the average yield to maturity on existing public bonds or ii) estimating bond rating based on credit statistics of comparable companies and referencing yields on recent offerings of comparable securities.
Preferred stock is not debt but a separate class of capital. The most common treatment for convertible securities in a WACC is to divide the convertibles into their debt and warrant/option components and add each part to either debt or equity. Debt should also be calculated net of excess cash. The required return on debt will increase as the debt/capital ratio increases and EBITDA/interest ratio decreases. is observable in the market and is best approximated by the current yieldtomaturity on the applicable debt securities. Remember regular preferred dividends are not tax deductible. we are assuming that our target company is profitable and has enough pretax profit to take full advantage of the tax deductibility of interest expense. ALL LIABILITIES ARE NOT DEBT for this purpose. leases etc.WEIGHTED AVERAGE COST OF CAPITAL Debt Cost of Capital The cost of debt or required return on debt. When using the aftertax cost of debt. Unless there is some reason to suspect that shortterm debt is seasonal or temporary. you should include it and current maturities as part of debt.e. Remember that the yield represents the market's expectation of future returns. short. "rd". a third category of capital in our WACC illustrations. . The general practice is to use one cost of debt for all senior debt i. long. Debt is typically understood to be liabilities with an explicit interest component.
the cost of equity should be correlated with the perceived risk of an investment (which generally increases with leverage). Fundamentally. subordinate to that of all classes of debt and preferred stockholders. Venture Capital Newer Technology Biotech High Return S&P 500 Pharmaceuticals Food Utilites Diversified Industrials Established Technology Low Low Gov’t Bonds Risk High .WEIGHTED AVERAGE COST OF CAPITAL Equity Cost of Capital Equity investors have a residual claim on the assets (value) of a company. Therefore. it is more difficult to estimate. Since the cost of equity is not readily observable in the market. The cost of equity or required return on equity (re) represents an investor's expected rate of return including dividends and capital appreciation. both the risks and expected returns to equity holders are greater.
The size of the risk premium is linearly proportional to the amount of risk taken. PE ratios have nothing to do with the cost of equity .WEIGHTED AVERAGE COST OF CAPITAL Capital Asset Pricing Model The Capital Asset Pricing Model (CAPM) is a tool to estimate required equity returns. Under CAPM. CAPM classifies risk into two parts: systematic risk and unsystematic risk. CAPM assumes that systematic risk is unavoidable and should be rewarded with a risk premium. Unsystematic risk is that portion of risk that can be avoided through diversification by the investor and therefore merits no premium return. The formula follows Cost of Equity = Risk free Rate + Beta(leveraged)* Market Risk Premium NOTE: There is no PE ratio in the formula. which is an expected return above the riskfree return.
currently the benchmark security. Many observers believe the current premium is no more than 34%. all else being equal. Sometimes practitioners add an additional premium of 13% for small cap companies as they are widely believed to offer greater risk and return. are worth more. Various studies support this assertion. . NOTE: This is another way of saying that larger companies.WEIGHTED AVERAGE COST OF CAPITAL Capital Asset Pricing Model The risk free rate is typically measured as the yield on the ten year Treasury Note. Some use the 30 year bond or even treasury bills. The market risk premium has averaged about 7% over time. In practice this is one of the most important assumptions of a DCF analysis. The market risk premium has proven to be surprisingly volatile over time. Market risk premium represents the expected market return minus the risk free rate of return.
The beta measures the degree to which a company's returns vary with the return of the overall market. we use historical betas in the classroom. Unless otherwise specified. Since the cost of capital is an expected value.WEIGHTED AVERAGE COST OF CAPITAL Beta Beta provides a method to measure the degree of an asset's systematic (nondiversifiable) risk. it is safe to assume that betas you are given are leveraged betas. A company whose stock has a beta of 1. Typically betas reported on popular websites like Yahoo are leveraged betas. however. the beta value should be an expected value as well.0 is as risky as the overall stock market and should therefore be expected to provide market returns to investors equal to that of the market. . The appropriate beta to use in the CAPM calculation is the leveraged beta. Generally.
or at the very least. Impute unleveraged betas from public comparables. b. Relever the average comparables unleveraged beta based on the company's target Debt/Capital ratio. adjust. sensitize. Make a judgment as to the appropriate beta for your analysis. c. Less liquid trading markets provide problematical data for beta calculations. Focus on the beta for the company you are valuing BUT It is useful check to: a. Betas are a difficult assumption as they can vary greatly from one information provider to another and are often at great variance with commonsense observations about business risk. If you have some reason to suspect your company’s beta.WEIGHTED AVERAGE COST OF CAPITAL CAPM Formula Use Bloomberg or other reputable source to determine the company beta. .
CAPM RIP?
The cornerstone theory of modern financial market analysis is under attack.
Key idea is that increased risks are accompanied by higher returns i.e. higher beta stocks are riskier but have higher returns Recent studies show that this is NOT TRUE over the long run.
Fama and French 2004 study discredits the model
CAPM woefully under predicts the returns of low beta stocks and massively overstates the returns of high beta stocks Over the long run there has been essentially no relationship between beta and return
Fama and French concluded that the theory’s empirical track record was so poor that its use in applications was probably invalid
BIG OOPS
WEIGHTED AVERAGE COST OF CAPITAL An Example : Black Mountain Beer's Cost of Equity
Assume the following:
Black Mountain Beer's Beta = 1.2 Risk Free Rate = 6.0% Equity Risk Premium = 7.5%
What is the cost of equity for Black Mountain Beer? re = rf + b L (rm  rf) re = 6.0% + 1.2 (7.5%) re = 6.0% + 9.0% re = 15.0%
WEIGHTED AVERAGE COST OF CAPITAL
An Example: Black Mountain Beer Company
Black Mountain Beer ("BMB") has 8,000,000 million common shares outstanding trading at $12.50 per share on the Asheville Exchange. BMB also has outstanding bank debt of $150 million at a 10% interest rate (1). Black Mountain Beer has a marginal tax rate of 38%. What is BMB's weighted average cost of capital? WACC =
D(1 T ) rd D E
+
E re D E
WACC = [10% x
150 250
x (1  .38)] + [15% x
100 250
]
WACC = [10% x 60% x (1  .38)] + [15% x 40%] WACC = 3.7% + 6.0% WACC = 9.7%
(1)
For purposes of this example, assume that 10% is also the current market cost of debt, as if Black Mountain Beer issued debt today. Furthermore, it is better to use 10 or 15 year debt, which better approximates the cost of funding the business.
When estimating an appropriate beta for a specific company.WEIGHTED AVERAGE COST OF CAPITAL Delevering and Relevering Beta Beta values measured in the market include the effect of leverage of the individual companies. you may want to estimate the appropriate range of unlevered betas or asset betas.T) x (Debt/Equity)) Where: b u = unlevered or asset beta b L = levered beta T = Marginal tax rate To relever the beta at a target capital structure: b L = b u * [1 + Debt (1T)] Equity . The Formula follows: b u = b L/(1 + (1 .
62 As shown above.2 1. without a highly leveraged balance sheet. however.T) E 1. .2 [1 + 150 (1 .93 = = = .WEIGHTED AVERAGE COST OF CAPITAL An Example : BMB's Unlevered & Levered Returns Black Mountain Beer's levered Beta was 1. What is BMB's unlevered Beta? bu bu bu bu = BL [1 + D (1 .38)] 100 1.2.. expected returns on Black Mountain Beer's equity are much less volatile. that was based on a leveraged balance sheet.
the companies Beta's differ more due to their different capital structures. We could then lever this average Beta to BMB's capitalization level and calculate an implied equity return and a WACC for BMB.09 1. (a) Unlevered Beta = BL : [1+(Debt/Equity) x (1Tax Rate)].45 1. To estimate its WACC. Levered Beta 1.07 Comparable Companies Clingman's Dome Beer Grandfather Mountain Beer Average Beta Note that on a leveraged basis. we could look at similar publiclytraded companies and estimate an average unleveraged Beta for companies like Black Mountain Beer.WEIGHTED AVERAGE COST OF CAPITAL An Example: Estimating Beta based on Similar Companies Assume Black Mountain Beer were a privately owned business and no estimate for its Beta existed. .06 1.35 Debt/ Equity 60% 25% Tax Rate 38% 40% Unlevered Beta (a) 1.25 1.
07 (7.07 = = Based on this estimate we can calculate an estimated return on equity and WACC for BMB: D E WACC = rd x (1 .t) x + re x re = rf + b (rm .rf) TotalCap TotalCap re = 6. we can estimate a levered Beta for BMB as follows: bL bL bL bL = Bu x (1+ Debt Equity x (1Tax Rate) ] = 1.07 and given its debt to equity of 150%.0% + 2.38) 100 1.07 x 1.53% WACC = WACC = 10% x (.33% 150 100 ] .53% x 250 12.07 x (1+150 x (1.5%) re = 21.62) x 250 + 21.WEIGHTED AVERAGE COST OF CAPITAL An Example: Estimating Beta Based on Similar Companies (cont'd) Assuming an unlevered Beta for Black Mountain Beer of 1.93 2.
5 UFCF = r = N = Unlevered Free Cash Flow Discount Rate Period (1) This method will result in a higher valuation of the cash flows. Discounting using a midyear convention simply requires each years cash flow being discounted by a period of onehalf a year less (1) : Present Value = UFCF1 (1+r)0.5 + + UFCFN (1+r)N. .5 + UFCF2 (1+r)1.5 + UFCF3 (1+r)2.DCF METHODOLOGY Present Value Calculations Present Value of Cash Flow Stream: The present value takes into account the time value of money by placing greater value on those cash flows generated earlier in the forecast period rather than later: Present Value = UFCF1 (1+r)1 + UFCF2 (1+r)2 + UFCF3 (1+r)3 + + UFCFN (1+r)N MidYear Convention: A midyear convention can also be used which assumes the cash flows occur in the middle of the period which often better approximates the time the cash is actually received.
348.2 1.685.5 23.703.5 712.3 1.3 21.0% 20.5% $2.3 967.4 12.5% 3.469.0 = 2.5 Projected FY Ended 12/31 2007E 2008E 2009E $585.091.071.5 12.4 5.0% 10.3 4.0 $40.3 1.0 0.38 $27.0 200.000.0 200.5% C Firm Value 3.256.0 0.1 216.5% 8.291.8 82.8 12. except per share) Actual FY Ended 12/31 2003 2004 2005 $400.8 141.3 992.5% $1.8 Assumptions: Sales Growth EBITDA Margin Increase in Depreciation Marginal Tax Rate CAPEX Growth Increase in NWC Shares Outstanding (millions) ($ millions.5 53.5% 3. except per share) Sales EBITDA Less: Depreciation EBIT Less: Taxes TaxEffected EBIT Plus: Depreciation Plus (Less): Increase (Decrease) in Deferred Tax Liability Less: CAPEX Less (Plus): Increase (Decrease) in NWC Free Cash Flow (FCF) FCF Growth Rate 2006E $532.5% $1.3 17.5 120.4 15.6 956.0 200.686.0 6.5 1.3 1.418.0 800.5% 8.65 $30.3 17.2 29.5% $1.0 13.0 $440.3 881.0 1.207.9 23.0 90.7 65.9 32.0% 8.0% D Net Debt a/o 12/31/05 $200.269.6 $644.6 109.DCF ANALYSIS – Perpetuity Method (dollars in millions.2 $708.2 54.009.5 16.412.0 0.4 $2.101.9 40.5% 9.72 $37.9 49.0% 8.19 $18.5% $52.2 720.8 1.5 36.056.0 22.1% $61.00 $21.0 80.0 20.5% 10.2 0.0 0.0 29.3 920.5 1.7 1.7 Discount Rate: 7.0 88.0 74.0% 40.5 19.5 1.8 1.2 59.095.0 0.426.049.218.252.42 Reference these from the balance sheet .5% $1.2 895.6 117.626.4 $2.2 14.8 13.4 1.0 857.2 14.5% $54.0 = F Total Equity Value 2.5 68.6 8.5 1.1 $69.23 $31.903.8 44.0 0.4 1.3 789.4 1.0 200.3 1.301.9 1.5 39.7 + B PV of Terminal Value at a Perpetual Growth Rate of [c] 2.0 79.4 106.148.0 10.9 213.46 $26.8 $1.0% 40.7 Value per Share 2.0 1.057.7 $1.209.54 $20.5 155.0 96.7 1.465.8 48.0% A Discounted Cash Flows (2006E2010E) $220.7 207.8 1.0 $484.3 21.4 1.2 1.5% 4.5 19.3 850.128.2 26.0 =((2010E FCF*(1+c))/(Discount Ratec))/(1+Discount Rate)^5 Discount Rate: 7.7 1.0% 20.3 2010E $779.1 $47.8 210.3 27.0 24.28 $42.0 4.14 $25.0% 10.3 16.0% 7.5% 9.01 $24.087.0 0.2 99.8 43.0% 7.58 $35.1 128.0 + E Equity Investments $0.44 4.5 1.167.485.4 0.4 132.5% $28.0 13.74 $22.5% 4.5% 3.7 72.7 17.
0x $36.776.9 23.324.0 $484.537.1 $69.3 16.687.1 216.0 96.48 $40.2 1.9 213.7 + B PV of Terminal Value as a Multiple of 2010E EBITDA [c] 13.8 210.3 1.5 1.6 $644.317.645.2 1.0 0.7 1.0 0.8 141.3 1.5 120.0x $1.3 1.3 4.8 48.3 17.6 109.5 16.0 200.8 12.576.5 39.0 0.0 6.0 0.565.6 Value per Share 13.737.0 79.451.4 1.12 $35.4 106.0 + E Equity Investments $0.2 1.5 1.0 74.71 $38.0 0.0x 14.556.5% 8.8 1.63 $39.0 13.0 80.9 32.527.8 82.83 $37.5 12.2 14.18 $35.0 29.2 59.6 1.2 1.0 13.0x 15.2 $1.8 = 13.2 2010E $779.667.5% C Firm Value 14.6 1.3 17.2 29.8 13.5 1.2 $708.19 Reference these from the balance sheet .5% Assumptions: Sales Growth EBITDA Margin Increase in Depreciation Marginal Tax Rate CAPEX Growth Increase in NWC Shares Outstanding (millions) =(2010E EBITDA*c)/(1+ Discount Rate)^5 Discount Rate: 7.591.765.5 1.411.5 2006E $532.66 $38.0% D Net Debt a/o 12/31/05 $200.0x 15.7 17.2 1.347.7 72.9 1.7 207.0% 7.5% 8.DCF ANALYSIS: EBITDA Multiple Method (dollars in millions.8 44.0% 7.1 128.15 $33.0x $1.0 200.426.445.5 68.0% 8.3 1.1 1.593.0% 8.519.0x $1.2 1.0 200.0% A Discounted Cash Flows (2006E2010E) $220.0 24.845.5 36.805.2 0.3 21.6 Discount Rate: 7.628.5% 9.2 1.8 43.4 15.379.5 155.499.5 23.665.520.662.1 1.3 Projected FY Ended 12/31 2007E 2008E 2009E $585.0 $1.4 132.13 $33.43 $41.0x $1.887.9 15.626.2 1.1 $47.2 99.428.0x $1.0 $440.2 54.5% $54.56 $39.0 22.9 1.0 90.9 1.465.3 27.3 1.6 8.0 200. except per share) ($ millions.358.96 $36.7 1.4 5.4 12.2 1.40 $42.0 1.1% $61.485.0 20.9 49.5 53.628.0 $1.0 = F Total Equity Value 13.0 88.2 26.5 19.9 1.1 $1.462.7 65.5 1.3 21.2 1.0 10.524.14 $34.3 1.393.0 $40. except per share) Sales EBITDA Less: Depreciation EBIT Less: Taxes TaxEffected EBIT Plus: Depreciation Plus (Less): Increase (Decrease) in Deferred Tax Liability Less: CAPEX Less (Plus): Increase (Decrease) in NWC Free Cash Flow (FCF) FCF Growth Rate Actual FY Ended 12/31 2003 2004 2005 $400.555.9 40.727.418.5% 9.558.6 117.4 0.0 0.0 0.2 14.0x 15.699.3 1.5 19.605.7 1.0x 14.0x 14.
6 g = 4.FCFn]/ [FCFn+EBITDA TVn] WACC = 8% FCFn = 69.5 EBITDA TVn at multiple of 14.0x = 2182.7% as compared to 3.48 – the Midpoint of the Summary? g = [(WACC * EBITDA TVn).5% Not too bad – it can be much more out of line very easily .GROWTH EQUIVALENCE OF EBITDA What Is Happening at $37.
3 million. using our formula to solve for ROIIC: 1.9 million from net cap ex.WHAT ABOUT ROIIC? This looks very suspicious here.598.598 = NOPATN+1 * (1 – g/ROIIC) WACC – g Solving for ROIIC yields ROIIC = 27. in 2008 incremental investment is $6. Better look deeper. a total of $10. If we drop the ROIIC to 8%. Therefore. Basically the projection assumptions are flawed.8% Not as bad as I thought it might be but still way too high compared to a WACC of 8%.9/(. Life isn’t this simple. but as a very crude measure. For example. In 2009 NOPAT increases by $6. the FV of the TV declines to 1.4%! . That in turn reduces the per share value from $27.4 million from working capital and $4.028 as compared to 1.54 to $17.7% g rates yields a ROIIC of 37..83.6/10. We believe the FV of the TV in 2010 using the perpetuity method is 69.035 = 71. Looking at the EBITDA approach with the derived 4. the ROIIC in 2009 is 6.035) = 1.6 million.5 * 1.598.08 .3 = 64%! We get an even more alarming number in 2010 – 69%.
the initial period net debt (total debt minus excess cash) needs to be deducted. Focus attention on your terminal value assumptions as they are typically by far the most important assumptions you will make in your analysis. DCF analysis using the cost of equity as the discount rate and leveraged cash flows to equity leads to an equity value. To determine equity value.DISCOUNTED CASH FLOW ANALYSIS Important Reminders Remember to insure that depending upon the free cash flows being used that you use the appropriate discount rate: Unleveraged cash flows Weighted Averaged Cost of Capital Ensure that the projections make sense and be sure to create sensitivity tables to determine which factors truly drive the valuation. Remember DCF analysis using a WACC for the discount rate and unleveraged cash flows leads to an enterprise value. .
Indeed the basic forecasts that are used are already subject to a certainty of error • Nonetheless our thinking must somehow include the value of these real options .DISCOUNTED CASH FLOW OFTEN UNDERSTATES VALUES Traditional DCF values expected cash flow and does not capture any value for real options • In the real world cash flows are contingent on the occurrence of future events • The ability to postpone or abandon projects or to change strategies has potentially significant value • The information required to properly value these options is typically not available.
• If operating leases are material. • Rents are treated like interest expense. • Operating leases are not capitalized but lurk in the financial footnotes. The common practitioner approach is to multiply current lease expense by eight to estimate this capitalized amount.DISCOUNTED CASH FLOW AND OPERATING LEASES Operating Leases • Debt numbers on the balance sheet already include capitalized leases so no further adjustment is necessary for them. • Similar approach can be used when doing comparable company analysis. • Lease expense is added to EBITDA to come up with EBITDAR for analysis purposes (R = rent). such as for retailers. . they should be discounted at the cost of debt and the discounted amount treated as debt.
DISCOUNTED CASH FLOW ANALYSIS Hierarchy of Valuation Techniques Real options and other complex valuation techniques Decision tree analysis Monte Carlo simulation Scenario DCF Simple DCF .
COMPARABLES ANALYSIS .
• Relies on the power of market based inputs. Calculate valuation multiples based on current markets. Why do we look at comparables? • • • • Provides a benchmark to value a company by referring to other "similar" publiclytraded companies with "similar" operating and financial statistics. . The exact ratios and statistics emphasized will vary from industry to industry. industry trends and growth. Provides insight into key valuation multiples for an industry. Serves as a value indicator for a passive.PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS Overview The analysis of publiclytraded comparable companies typically consists of a comparison of several companies’ operating and trading statistics. minority investment.
The analyst is often making judgments and compromises. . companies often strive to distinguish themselves from others. NOTE: All companies do not have publicly traded comparables. • It is extremely difficult to find truly comparable companies. We may have to think outside the box. small capitalization or underresearched stocks.PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS Issues With Comparables • WHAT IF THE COMPS ARE WRONG!!?? i.e. • May not reflect an appropriate value in thinly traded. In fact. We are assuming that the comparable valuations are correct. Yahoo is a good comp for Google but how confident are we about Yahoo’s valuation?? REMEMBER – comps analysis is entirely relativistic.
• Comparable analysis is probably more vulnerable to accounting issues than DCF analysis. • Comparables analysis does not focus on free cash flow and offers only a limited look into the explicitly forecast future. • It does not account for "control" premiums or potential synergies realized in an acquisition. .PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS Issues With Comparables • The quality of the ―answers‖ is highly dependent on the quality of the comparables and on the specific comparables chosen.
These factors are not necessarily determinative in isolation. Is the industry the same? Is there a high degree of similarity between customer types. Margins can be important as well. By far the most important thing to consider is the nature of the underlying business. Few companies are truly comparable with one and other. Growth can also be important. Identifying comparables can be a major challenge. and economic drivers of the business? Size can be important. . If none of these things are similar you may not have found a comparable.COMPARABLE COMPANY ANALYSIS What Makes a Company Comparable? Comparables analysis is often a highly subjective area where nothing is always true. Sometimes there are no true comparables and you may need to think out of the box. products offered.
.e. the current stock price divided by forecasted EPS. DCF is less commonly used in IPO valuations.g. current EV/forecasted EBITDA (or EBIT or Sales. For example by May 2007 investors will be starting to rely more on Current Price/2008 forecasted EPS.) Generally by late spring investors are starting to look forward another year. The same is true of enterprise multiples i.) • Multiples are most useful when they look forward e.PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS Other Things to Keep in Mind • For IPO valuations this analysis yields fully distributed value before the IPO discount (actually this would be true as well if you were using a DCF to value a company for an IPO. the year 2007 no longer is that much of a forecast and the emphasis will have shifted to a focus on 2008. By September 2007.
COMPARABLE COMPANY ANALYSIS What are the key ratios? ENTERPRISE VALUES EQUITY VALUES ENTERPRISE VALUE/EBITDA ENTERPRISE VALUE/EBIT ENTERPRISE VALUE/REVENUES ENTERPRISE VALUE/SUBSCRIBERS OR OTHER METRIC PRICE/EPS PE/G (―PEG Ratio‖) PRICE/BOOK VALUE PER SHARE It is imperative to understand the difference between Equity Value and Enterprise Value and their respective multiples. A multiple that has debt in the numerator must have a statistic before interest expense in the denominator. The difference lies in the treatment of debt and its cost. . interest expense.
COMPARABLE COMPANY ANALYSIS Things to Keep in Mind Enterprise ratios minimize the impact of leverage among companies with different capital structures Enterprise ratios also eliminate accounting differences related to depreciation and amortization and taxes Leverage influences P/E ratios in the following ways: If EBIT/EV > cost of debt then leverage understates P/E If EBIT/EV < cost of debt then leverage overstates P/E If a company has a high P/E ratio it may be ―cheaper‖ from an EPS dilution notion of the cost of equity to sell stock than to issue debt. exactly the opposite of the real economic situation .
The key problem is that it ignores profitability. Focus on forward ratios. On the other hand using EBIT does not help minimize the impact of depreciation and amortization differences. This is typically used for young companies without profits or even EBITDA. Therefore.COMPARABLE COMPANY ANALYSIS Which Ratios Should You Use? All of them! They are easy to calculate and you might learn something. Emphasize PEs. EBIT is generally a better measure than EBITDA but EBITDA is more commonly used. For many companies. EV/EBIT. Remember neither EBITDA nor EBIT represents free cash flow. EV/Revenues is possibly okay depending on circumstances. EV/EBITDA. if in fact they do. capital expenditures > depreciation. some prefer EBIT as a better proxy for free cash flow. Try and understand why PEs and enterprise ratios give a different answer. and PEG ratios. Look at both to be safe. .
perhaps because g is more predictable for them. The concept is what price in terms of PE ratio is an investor paying for a percentage of growth rate. Slower growth companies often have higher PEGs.COMPARABLE COMPANY ANALYSIS PEG Ratios and Price/Book PEG ratios are commonly used. like everything else in the world of comps. this is a relativistic concept. especially with growth companies. PEG ratios are typically calculated as forward PE/five year or secular growth rate * 100. A PEG ratio of less than one does not mean the stock is necessarily cheap. Remember. Deemphasize this ratio as a general matter. Note that if the company has zero g it has no value! Ridiculous! Price/book is the most dubious of all ratios. PEG ratios have a dubious intellectual validity but are widely used. The PEG for the S&P 500 is about 1. . Focus on the comps when thinking about this.8x. It may have more validity when looking at financial services companies.
Exclude outlying multiples. use common sense. It is better to focus on one or two really good comps then six or eight sort of comparable companies. This doesn’t mean that you want to completely ignore ―sort of‖ comps. high and low multiples and multiples of specific companies which may be particularly relevant and comparable.) given the company and the nature of its business. These can hide lots of useful information. Sales.PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS Deriving Valuations Once you have calculated relevant multiples for each comparable company. Use judgment to determine which multiples are most relevant (Net Income. Analyze results and decide which companies are most comparable. EBITDA. Look at mean and median multiples. you must then determine which multiples or range of multiples justify a reasonable benchmark for valuation of the specific target. etc. Don’t allow yourself to become overly focused on means and medians. . EBIT. Don’t make the universe of truly comparable companies greater at the expense of diluting the quality of the information that you have.
TRADING MULTIPLES VS. not accounting earnings Theoretically correct Time consuming and complex Highly sensitive to cost of capital and terminal value assumptions Wide range of forecasts possible DCF . DCF Pros and Cons PROS Easy to use No terminal value estimate to worry about Captures information provided by an efficient market Good crosscheck for DCF CONS Pure comparables rarely exist Potentially distorted by accounting Not focused on cash flow Disguises lots of assumptions made by the market Are the relative valuations believable? Limited explicit focus on the future Trading Multiples Captures explicit outlook for the business being evaluated Driven by cash flow.
e. The purpose is similar to that of public comparables analysis except that by looking at prior acquisitions. control premium) of the target company. Typically even more difficult to find true comparables When preparing "acquisition comps". This greatly complicates things as valuation parameters like interest rates and stock market values can vary greatly over time.COMPARABLE ACQUISITION TRANSACTIONS Overview The comparable acquisition transactions analysis contains information about selected acquisition transactions in the same industry as the company being evaluated.. Friendly . Stock Hostile vs. insight can be gained for the premium paid to gain control (i. Status of deal – Completed? Pending? Withdrawn? Consideration: Cash vs. consider the following: Time frame is typically five years.
the primary economic driver of M&A activity. What they are buying (market share.COMPARABLE ACQUISITION TRANSACTIONS Objectives of Comparisons of Acquisition Transactions Measures Private Market Value ("Control Value") However. Relative Activity b. How much are buyers paying? DO NOT RELY ON ACQUISITION COMPARABLES UNLESS YOU ARE VALUING A COMPANY FOR THAT PURPOSE .)? d. does not directly deal with the value of synergies. technology. Develop Understanding of M&A Activity in Industry a. Who is buying? c. etc.
and legal issues .COMPARABLE ACQUISITION TRANSACTIONS Many Factors Influence Price Number of buyers Synergies – these vary from company to company Availability of alternative targets Competition among investors DCF values Comparables Nonprice issues – i. accounting.e. governance Transaction structure Tax.
APPENDIX .
Other common synergies include working capital and capital expenditure savings. Allow for any incremental investments that may be required to produce the synergies Assign a terminal value based on the perpetuity growth formula Discount to present value using the target’s WACC or cost of equity .DISCOUNTED CASH FLOW ANALYSIS .SYNERGIES There are two general approaches to valuing synergies in mergers and acquisitions. Typically we look at a three to five year forecast Tax effect the cost savings and similarly make sure you are dealing with after tax cash flow. These are typcially broken into two components – revenue synergies and cost synergies. The difference can be seen as synergies More commonly we analyze the synergies themselves – the additional cash flow anticipated to be created as a result of the mergers. as relates to the revenue synergies. Analyze the forecast for the target with and without the transaction. You may need to reduce revenue estimates to operating income to after tax cash flow. not revenues.
) –The different characteristics of each business segment (betas. –Often assumptions must be made about how to allocate expenses. etc. terminal value assumptions.COMPANIES WITH MULTIPLE BUSINESS LINES ARE OFTEN VALUED ON A SUM OF OF THE PARTS BASIS This approach is sometimes referredto as a ―breakup‖ valuation. –Typically less detailed financial data is publiclyavailable for segments. Completing a sumoftheparts valuation is more challenging than a straightforward (singlebusiness/consolidated) comparable or DCF analysis. .) must be considered. DCF analysis may also be used for the some or all of the parts. – Highlights the market discount for diversified companies. – Particularly common when the parts have different financial and growth characteristics. which can then be used with appropriate multiples or growth rates in order to arrive at a value for each part. EBITDA and/or net income). especially those that are clearly shared across businesses (like corporatelevel SG&A. The methodology requires estimating financial results for each business (EBIT. If sufficient information is available.
the deal will be dilutive because the acquirer is buying less EPS than the target shareholders are accepting as consideration –Remember to take the premium into account when calculating the target’s P/E –Utility of comparison will also depend on transaction assumptions regarding goodwill impairment or other asset amortization For 100% cash transactions. the deal will be accretive because the acquirer is buying more EPS than the target shareholders are accepting as consideration –If the acquirer has a lower P/E than the target. the deal will be accretive –Where the inverse cost of debt is lower than the P/E of the target. the cost of debt (interest payments) and cost of acquiring the target’s earnings will determine the accretive or dilutive impact of a transaction –Where the inverse cost of debt (1/(aftertax cost of debt)) is greater than the P/E of the target.THE ROLE OF P/E RATIOS AND INTEREST PAYMENTS IN EPS DILUTION AND ACCRETION ANALYSIS For stockforstock deals. accretion or dilution potential will usually be evident by simply comparing the P/E multiples of the acquirer and the target –If the acquirer has a higher P/E than the target. the deal will be dilutive .
e. EBITDA = $100 –FV / EBITDA = 10.5x . EBITDA = $100 –FV / EBITDA = 9.DEALING WITH MINORITY INTERESTS AND EQUITY IN UNCONSOLIDATED AFFILIATES Minority interest Minority interest represents the portion of a consolidated subsidiary which you do not own Equity interest Equity interest in unconsolidated affiliates represents a minority stake you hold in another company Need to make sure the numerator and denominator of a trading multiple are on an applestoapples basis –Numerator: Add the minority interest (market value if available or book value) to firm value –Denominator: Consolidated financial results Need to make sure the numerator and denominator of a trading multiple are on an applestoapples basis –Numerator: Subtract the equity interest (market value if available or book value) from firm value (i. treat as cash) –Denominator: Consolidated financial results (do not include equity interest) Consider the following example: –Market cap of $500MM –Debt of $500MM –Consolidated EBITDA of $100MM –Minority interest of $50MM Consider the following example: –Market cap of $500MM –Debt of $500MM –Consolidated EBITDA of $100MM –Equity interest of $50MM Firm Value = $1050.5x Firm Value = $950.
. For an M&A analysis. Convert derived Enterprise Values to Equity Values by subtracting Net Debt. LTM results (LTM = latest twelve months) Projected fiscal year results Select relevant multiple range 2. and diluted shares outstanding should be used. Sales multiples EBITDA multiples EBIT multiples 4. Convert derived Equity Values to Enterprise Values by adding Net Debt. Net Income/EPS estimates multiples Book Value multiples 3. Per Share Values can be obtained by dividing Equity Values by shares outstanding. Multiply operating results of company to be valued by relevant comparable company multiples.PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS Imputing Values – Things to Remember 1. Net Debt should be adjusted for convertible securities and option/warrant proceeds.
PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS Imputing Values – Formulas Implied Values EPS — Target EPS x Relevant multiple from set of comparables —(Comparable Net Income multiple x Target Net Income) Target Shares Outstanding Net Income EBIT — ((Comparable EBIT multiple x Target EBIT) – Target Net Debt) Target Shares Outstanding EBITDA — ((Comparable EBITDA multiple x Target EBITDA) – Target Net Debt) Target Shares Outstanding — ((Comparable Sales multiple x Target sales) – Target Net Debt) Target Shares Outstanding Sales .
31 $87.92 ($88.0 6.0 mm $70.2x $539.PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS Imputing Values – An Example Using Means and Medians Assume Rookie Enterprises has the following financial information: Dec97 EPS: Dec98 EPS: LTM EBITDA: LTM EBIT: Net Debt: Diluted Shares Outstanding: Financial Result $2.80 What is the implied equity per share value of Rookie Enterprises on an LTM EBITDA? LTM EBITDA x Mean Multiple: = Implied Market Capitalization .7x 6.2x 8.31 $8.0 mm 14.0) $451.6 $30.4 $87.83 $3.0x What is the implied equity per share value of Rookie Enterprises on a Dec98 EPS basis? Dec98 EPS: x Mean Multiple: = Implied Equity Per Share Value $3.6 mm Mean Multiple of Public Comparables 9.7 mm $88.Net Debt = Implied Market Value / Diluted Shares Outstanding = Implied Equity Per Share Value 14.3x 8.7x $28.4 .
Implies relevant range of valuation multiples (i. implied multiples should be calculated.e. such as DCF. how much should someone pay for the target).PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS Imputing Multiples After determining a range of values under different methodologies.. Formulas: EPS — Imputed Value Per Share Target EPS (Imputed Value Per Share x Target Shares Outstanding + Target Net Debt) Target EBIT (Imputed Value Per Share x Target Shares Outstanding + Target Net Debt) Target EBITDA (Imputed Value Per Share x Target Shares Outstanding + Target Net Debt) Target Sales EBIT — EBITDA Sales — — .
3x 8.0 7.6 $522.6 mm Mean Multiple of Public Comparables 9.2x 8.5x What is the implied LTM EBITDA multiple if the high end of the Public Comparables valuation range is $35.83 11.0 .0 $610.83 $3.0 mm $70.0x $88.7 mm $88.0 mm 14.31 $87.50? Equity Per Share Valuation / 1997 EPS = Implied 1997 EPS Multiple $32.0 $35.75? Equity Per Share Valuation x Diluted Shares Outstanding: = Implied Market Value + Net Debt = Implied Market Capitalization / LTM EBITDA = Implied LTM EBITDA Multiple $87.0x What is the implied 1997 EPS multiple if the low end of the Acquisition Comparables valuation range is $32.7x 6.PUBLICLY TRADED COMPARABLE COMPANY ANALYSIS Imputing Multiples – An Example Using Highs and Lows Recall Rookie Enterprises has the following financial information: Dec97 EPS: Dec98 EPS: LTM EBITDA: LTM EBIT: Net Debt: Diluted Shares Outstanding: Financial Result $2.75 per share 14.50 per share $2.
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