Valuation: A Conceptual Overview: Streetofwalls

31/8/22, 23:16 Valuation: A Conceptual Overview | Street Of Walls
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VALUATION: A CONCEPTUAL OVERVIEW

of Investment Banking Technical Training
In this chapter we will introduce the reader to some key, high-level concepts required to understand
valuation and how it’s done on Wall Street. We will cover three key topics:
Enterprise Value: The 30,000-Foot View
Understanding Enterprise Value vs. Market Value

An Introduction to Valuation Techniques
Enterprise Value: The 30,000-Foot View
Investment bankers use four primary valuation techniques when advising corporate clients. These
techniques apply almost universally, regardless of the company, industry or circumstance. They will be
introduced in the next chapter, Valuation Techniques Overview.
But how are the valuation techniques actually constructed? When should which technique be used?
What are the basic building blocks required for them? We will find more detailed answers to some of
these questions in the next chapter. However first we’re going to take a step back and explain some of
the building blocks of these valuation techniques so that they make sense when we later discuss them in
technical depth.
In this chapter, therefore, you will find a detailed overview of the core building blocks of the valuation
techniques used by investment bankers.
Enterprise Value (frequently referred to as EV—not to be confused with Equity Value, which is
another name for Market Value of a company) is the core building block used in financial modeling.
The reason is this: Enterprise Value is designed to represent the entire value of the company’s
operations. By contrast, Market Value is a residual: it represents the value of the company remaining
once the value ascribed to other stakeholders (non-owners) has been taken out.
Enterprise Value must therefore account for all of the differences between Market Value (remember,
this figure is the Market Value of a company’s Equity or ownership) and the Value of Operations (or
Operating Value) of a Company.

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Let’s start with a basic identity equation:
Enterprise Value =
Operating Value of a Company =
Net Value of all the Claims on the Company’s Assets (Excluding Excess Cash)
This equation is simple enough. Assuming that the company is profitable, and that it’s more valuable in
operation than in liquidation (in other words, the company is worth more money if it continues in
business rather than stopping business and selling off the assets to the highest bidders), the value of the
company is equal to the value of its productive operations. This value must also equal the value of all of
the net claims against the company’s assets, because these assets are being used to produce money for
these claimants, or stakeholders (assuming, of course, that these claims have been valued correctly).
The “Excluding Excess Cash” piece will be explained in a moment.
The net value of all the claims on a company’s assets can be broken down as follows:
Debt: Money that has been lent to the company by another person or institution. Debt holders
have a higher priority than equity holders on the claims of the company’s assets and value, so
they get paid first. In order to get to EV, we must add Debt to the Market Value of the company’s
Equity.
Cash: Money that is owned by the company—in other words, it’s sitting on the company’s
balance sheet. This money, assuming it is not required by the operations of the business, could be
used to pay off existing claimants, or stakeholders. (For example, the cash could be used to pay
off Debt; it could also be used to repurchase outstanding shares in the company’s Equity.) Thus
the higher the Cash balance a company has, the less its operations must be worth. This concept is
counterintuitive: shouldn’t owning more cash be a good thing? Yes, in a sense it is—but assume
for a moment that a company’s Market Value (of Equity) is fixed at a certain dollar amount. That
value can be ascribed to only two sources: (1) the residual claim value on a company’s operations
after all other stakeholders have been paid off, and (2) the value of the money on the company’s
balance sheet. The higher (2) is, the lower (1) is, and vice versa. Therefore, to get to EV, we must
subtract Cash from the Market Value of the company’s Equity. (This is one way of looking at it.
In practice, Cash is often subtracted from Debt to get an important statistic called Net Debt. Net
Debt is the value of the Debt once balance sheet Cash has, hypothetically, been used to pay some
of it off. Diagrams below will explain the different ways of conceptualizing this.)
Minority Interest: This is a tricky one. Corporations often have a Liability account called
Minority Interest (MI). This is a special accounting designation for a specific scenario: when a
Corporation owns most, but not all, of a subsidiary company. If that is the case, the subsidiary
company is consolidated entirely into the Corporation’s financial statements, so that it would

appear, at first glance, that the Corporation does indeed own 100% of that subsidiary. In fact it
does not, so this Liability account is created to represent the value of the shares owned in the
subsidiary by other individuals or companies. (Similarly, there will be a corresponding Minority

Interest expense on the Income Statement for the Corporation, representing the portion of value
from the subsidiary’s operating results that actually belongs to the other shareholders in the
subsidiary.) Since this MI represents the value of the partial ownership (by others) in this
subsidiary, it should be treated like Debt – that is, in order to get to EV, we must add Minority
Interest to the Market Value of the company’s Equity. (We should keep in mind, then, that this
EV statistic will include the entire value of the company’s subsidiary, even though the
Corporation itself does not own 100% of it.)
Preferred Equity: Despite the name, Preferred Equity primarily operates as Debt, not Equity.
It is junior to all other forms of Debt, but it is also senior to the Equity (often called Common
Equity or just “common.”) Often, Preferred Equity can be converted to shares of Common
Equity, hence the name. It may be convertible to Common Equity but, until that time, it receives
interest and is in line ahead of the Common Equity in the capital structure, so it is “preferred” to
the common shares. It receives preferential treatment. Because Preferred Equity is actually
primarily Debt unless and until it is converted to Equity, we must add Preferred Equity to the
Market Value of the company’s (Common) Equity.
Visually, we can look at this two different ways:
1. ENTERPRISE VALUE + CASH = TOTAL VALUE OF ALL CLAIMS
2. ENTERPRISE VALUE = NET VALUE OF ALL CLAIMS

Typically, investment bankers and investors look at this equation the second way (the Net Debt/Net
Value version). This is the one to be most familiar with.
ANOTHER VIEW OF ENTERPRISE VALUE
There is another way of looking at EV: core assets vs. non-core assets. Core assets are used to generate
profit for the business; non-core assets are things owned by the business but not central to its money-
generating operations.
Core Assets: assets critical to the operating business, such as Inventory, Fixed Assets, Accounts
Receivable, etc.
Non-Core Assets: assets not critical to the operating business such as Derivatives, Currencies,
Real Estate, Commodities, Stock Options, etc.
In this sense, Cash on the Balance Sheet usually (at least for the most part) is non-core. Unless it’s cash
that the business needs to operate (such as dollar bills in the registers at a retail operations), it is not
being used to generate profit in the business operations. That’s why it is stripped out in EV calculations.
(Other non-core assets may be as well, especially if they can be sold off for cash without harming the
operations of the business. For example, Real Estate and Commodities can often be sold without
impacting the Company’s cash-generating operations.)
Therefore Cash is (generally) a non-core asset. Other similar assets, such as Marketable Securities, are
simply ways of attempting to earn profit on that Cash, but are not core to the company’s operations.
These Cash-like assets can also be sold off, and should be stripped out of the Net Debt Calculation.
PRIMARY COMPONENTS OF NET DEBT

(+) Short-Term Debt: Debt with less than one year maturity.
(+) Long-Term Debt: Debt with more than one year maturity.
(+) Debt Equivalents: Operating Leases and Pension Shortfalls.
(–) Cash and Cash Equivalents: Cash, Money Market Securities, and Investment Securities

Notice in this list that “Cash and Cash Equivalents” is a subtraction from the calculation—Cash and
Cash-like assets are thus a sort of “anti-Debt.” Debt can also come in several different flavors, but on the
Balance Sheet it’s almost always broken down into Short-Term Debt and Long-Term Debt. This is
because Short-Term Debt is coming due soon (within less than a year), and thus must be paid off or
refinanced in the near future. This may be of interest if the company is having financial trouble—the
due date on the near-term Debt may trigger difficulties for the Company in terms of repayment. This
type of difficulty, which can end up being a crisis under the right circumstances, is called a liquidity
problem (or crisis).
Understanding Enterprise Value vs. Market Value
Nearly all valuation techniques will focus on either Enterprise Value or Market Value (or Equity). So
which do we use, and when? In a nutshell:
Techniques related to the value available to shareholders should focus on Market Value
(of Equity).
Similarly,
Techniques related to the value available to all stakeholders should focus on Enterprise
Value.
Let’s start by looking at three commonly used trading multiples:
EV/Sales: Enterprise Value ÷ Sales (or Revenue)
EV/EBITDA: Enterprise Value ÷ EBITDA (Earnings before Interest, Taxes, Depreciation &
Amortization)
Price/Earnings (or P/E): Market Value of Equity ÷ Net Income (alternatively, Stock Price ÷
Earnings Per Share, or EPS)
Notice that in the first two examples, Enterprise Value is used. This is because Sales and EBITDA
generate profit/value that is available to all stakeholders. No compensation has yet been taken out for
non-Equity stakeholders. By contrast, Price/Earnings reflects the Net Income for a company, which is
computed after compensation for other stakeholders has been removed (Interest Expense and
Minority Interest). Therefore, this profit/value is only available to Equity stakeholders.
People new to valuation may ask, “Why is it incorrect to use Market Value/EBITDA or Enterprise
Value/Net Income?” The answer lies in the fact that for any multiple, the denominator and numerator
within that multiple must either include or exclude leverage. In other words, both the numerator and
denominator must both relate to either all stakeholders or only shareholders. Otherwise, comparisons

across companies will not be “apples-to-apples”—they will be difficult to compare because different
companies utilize different amounts of leverage.
This concept is demonstrated in the following graphic:
In summary:
Enterprise Value matches with Revenue, EBITDA and EBIT—items found before Interest
Expense (and Minority Interest, where applicable) on the Income Statement.
Conversely,
Market Value matches with Pre-Tax Income (sometimes called Earnings Before Taxes, or
EBT), Net Income, and Earnings Per Share—items found after Interest Expense (and
Minority Interest, where applicable) on the Income Statement.
An Introduction to Valuation Techniques
You will read about the four main valuation techniques for Investment Bankers in great detail in the
upcoming chapters. Here is a brief overview of them all, with this concept of Enterprise Value vs.
Market Value in mind:
COMPARABLE COMPANY ANALYSIS

Comparable Company Analysis, frequently referred to simply as “Comps,” is a valuation
technique used to find company values based on traded values of similar (comparable)
companies.
Comps a market-based valuation analysis relying on current market prices for publicly traded
companies.
Comps valuation can revolve around either the Enterprise Value of the company or the
Market Value of the company, depending on the multiples being used. For example, EV/Sales
or EV/EBITDA multiples would refer to Enterprise Value, while Price/Earnings multiples
(equivalent to Market Value/Net Income) would refer to Market Value.
THE THREE MAIN STEPS OF A COMPS VALUATION
1. Identify publicly-traded companies with characteristics similar to those of the company being
valued.
2. “Spread” the Comps—i.e., map-out the trading multiples (EV/Sales, EV/EBITDA, and P/E) for
this set of comparable companies.
3. Assign these multiples to company financial results to determine valuation ranges.
COMPARABLE COMPANIES ANALYSIS EXAMPLE
ABC Company is currently generating annual Net Income of $150 million.

Publicly traded comparable companies are trading, on average, at 10x current year Net Income.
How much is the Equity of this company worth?
Using Comparable Company Analysis, this company’s Equity is worth $1.5 billion based on $150 million
of Net Income and the comparable company average of 10x Net Income. Note that a proper range of the
valuation can be obtained by looking at the highest and lowest Net Income multiples in the comparable
companies set.
DISCOUNTED CASH FLOW (DCF) ANALYSIS

DCF analysis values a company by projecting its future Free Cash Flows (FCF) and then using
the Net Present Value (NPV) method to value the firm.
DCF valuation builds off of Free Cash Flow forecasts that are typically done for the upcoming 5 to
10 years.
DCF valuation primarily returns the Enterprise Value of the company, because Free Cash
Flow refers to the cash generated by the operations of a business, irrespective of Net Debt and
Minority Interest/Preferred Equity. However a DCF model can also be used to project Market
Value if Interest Expense and Minority Interest are projected and stripped out to produce
Levered Free Cash Flows (LFCF).
THE FOUR MAIN STEPS OF A DCF VALUATION
1. Forecast out a company’s Free Cash Flows for the next 5-10 years.
2. Calculate the Weighted Average Cost of Capital (WACC).

3. Calculate the firm’s Terminal Value, or the future value of the firm assuming a stable long-
term growth rate.
4. Discount 5-year Free Cash Flows plus Terminal Value back to Year 0 (today) to derive the
Enterprise Value of the company.
Free Cash Flows are discounted back to Year 0 (today) to solve for Enterprise Value, as displayed in this
graphic:
PRECEDENT TRANSACTION ANALYSIS

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

Price/Earnings multiples (equivalent to Market Value/Net Income) would refer to Market Value.
The most commonly used transaction multiples are EV/Sales, EV/EBITDA, and P/E.
THE THREE MAIN STEPS OF PRECEDENT VALUATION
1. Identify publicly traded companies with similar characteristics.
2. “Spread” the comps or map-out trading multiples such as EV/Sales, EV/EBITDA, and P/E.
3. Assign industry multiples to company figures to determine valuation ranges.
PRECEDENT TRANSACTION ANALYSIS EXAMPLE
PDQ Company is currently generating annual Net Income of $150 million.
Precedent M&A transactions since 2004 have shown industry average of 20x P/E (see image
below).
How much is the Equity of this company worth?
Using Precedent Transaction Analysis, PDQ’s Equity is worth $3.0 billion based on $150 million of Net
Income and the precedent P/E multiple of 20x Net Income. Note that a proper range of the valuation
can be obtained by looking at the highest and lowest Net Income multiples in the precedent
transactions set.
LEVERAGED BUYOUT (LBO) ANALYSIS

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

LBO acquirers are typically Private Equity sponsors.
This is a transaction-based valuation technique. Private Equity buyers typically look to sell the
business within 5 years after purchase.

LBO valuation revolves around the Enterprise Value of the company, because the entire
business will be acquired and all (or essentially all) of the pre-existing Debt will be paid off.
THE FIVE MAIN STEPS IN AN LBO ANALYSIS
1. Make transaction assumptions based on the purchase price, Debt interest rate, etc.
2. Build the Sources & Uses table, where “Sources” lists how the transaction will be financed and
“Uses” lists the capital uses—i.e., where the “Sources” money will be spent.
3. Adjust the Balance Sheet for the new Debt and Equity, and other transaction-related
adjustments.
4. Project out the three financial statements (usually 5 years) and determine how much Debt is paid
down each year.

5. Calculate exit value scenarios based on EBITDA multiples.
←Introduction Valuation Techniques Overview→
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31/8/22, 23:17 Valuation Techniques Overview | Street Of Walls
VALUATION TECHNIQUES OVERVIEW

Investment banks perform two basic, critical functions for the global marketplace. First, investment
banks act as intermediaries between those entities that demand capital (e.g. corporations) and those
that supply it (e.g. investors). This is mainly facilitated through debt and equity offerings by
companies. Second, investment banks advise corporations on mergers & acquisitions (M&A),
restructurings, and other major corporate actions. The majority of investment banks perform these two
functions, although there are boutique investment banks that specialize in only one of the two areas
(usually advisory services for corporate actions like M&A).
In providing these services, an investment bank must determine the value of a company. How does an
investment bank determine what a company is worth? In this guide you will find a detailed overview of
the valuation techniques used by investment bankers to facilitate these services that they provide.
In this chapter we will cover two primary topic areas:
How do bankers determine how much a company is worth—in other words, what valuation
techniques are typically used?

What are the advantages and disadvantages of each valuation technique, and when should which
technique be used?
Valuation Techniques: Overview
While there are many different possible techniques to arrive at the value of a company—a lot of which
are company, industry, or situation-specific—there is a relatively small subset of generally accepted
valuation techniques that come into play quite frequently, in many different scenarios. We will describe
these methods in greater detail later in this training course:
Comparable Company Analysis (Public Comps): Evaluating other, similar companies’
current valuation metrics, determined by market prices, and applying them to the company being
valued.
Discounted Cash Flow Analysis (DCF): Valuing a company by projecting its future cash
flows and then using the Net Present Value (NPV) method to value the firm.

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Precedent Transaction Analysis (M&A Comps): Looking at historical prices for completed
M&A transactions involving similar companies to get a range of valuation multiples. This analysis
attempts to arrive at a “control premium” paid by an acquirer to have control of the business.
Leverage Buyout/“Ability to Pay” Analysis (LBO): Valuing a company by assuming the
acquisition of the company via a leveraged buyout, which uses a significant amount of borrowed
funds to fund the purchase, and assuming a required rate of return for the purchasing entity.
These valuation techniques are easily the most commonly used, other than in valuations for specific,
niche industries such as oil & gas or metal mining (and even in those industries, the aforementioned
valuation techniques frequently come into play). Different parts of the investment bank will use these
core techniques for different needs in different circumstances. Frequently, however, more than one
technique will be used in a given situation to provide different valuation estimates, with the concept
being to triangulate a company’s value by looking at it from multiple angels.
For example, M&A bankers are typically most interested in Transaction and Comparables valuation for
acquisition and divestiture. Equity Capital Markets (ECM) bankers underwrite company shares in the
public equity markets in advance of an initial public offering (IPO) or secondary offering, and thus rely
heavily on Comparables valuation. Financial sponsors and leveraged finance groups will almost always
value a company based upon leveraged buyout (LBO) transaction assumptions, but will also look at
others. Also, in many cases, all of these groups will employ some degree of DCF valuation analysis.
These different divisions of an investment bank may come up with similar valuation ranges using some
subset of the techniques given, but will approach this process often with entirely different goals in mind.
Thus all of these techniques are used routinely by investment banks, and for a banking analyst, at least
some degree of familiarity with all of these techniques must be achieved in order for that analyst to be
considered proficient at his or her job.
When To Use Each Valuation Technique
All of the valuation techniques listed earlier should be practiced by a junior banker, but some may be
more applicable than others, given the group, the client, and the exact situation.
The Comparable Company valuation technique is generally the easiest to perform. It requires that the
comparable companies have publicly traded securities, so that the value of the comparable companies
can be estimated properly. We will detail the calculation process for Comparable Company analysis
later in this guide.

The analysis is best used when a minority (small, or non-controlling) stake in a company is being
acquired or a new issuance of equity is being considered (this also does not cause a change in control).
In these cases there is no control premium, i.e., there is no value accrued by a change in control,
wherein a new entity ends up owning all (or at least the majority) of the voting interests in the business,
which allows the owner to control the company cleanly. With no change of control occurring,
Comparable Company analysis is usually the most relied-upon technique.
DISCOUNTED CASH FLOW ANALYSIS (DCF)
A DCF valuation attempts to get at the value of a company in the most direct manner possible: a
company’s worth is equal to the current value of the cash it will generate in the future, and DCF is a
framework for attempting to calculate exactly that. In this respect, DCF is the most theoretically correct
of all of the valuation methods because it is the most precise.
However, this level of preciseness can be tricky. What DCFs gain in precision (giving an exact estimate
based on theory and computation), they often lose in accuracy (giving a true indicator of the exact value
of the company). DCFs are exceedingly difficult to get right in practice, because they involve predicting
future cash flows (and the value of them, as determined by the discount rate), and all such predictions
require assumptions. The farther into the future we predict, the more difficult these projections
become. Any number of assumptions made in a DCF valuation can swing the value of the company—
sometimes quite significantly. Therefore, DCF valuations are typically most useful and reliable in a
company with highly stable and predictable cash flows, such as an established Utility company.
Because DCFs are so difficult to “get perfect,” they are typically used to supplement Comparable
Companies Analysis and Precedent Transaction Analysis (discussed next).
The Precedent Transaction valuation technique is also generally fairly easy to perform. It does require
that the specifics of a prior acquisition/divestiture deal are known (price per share, number of shares
acquired or spun off, amount of debt assumed, etc.), but this is usually the case if the target (acquired
company) had publicly traded instruments prior to the transaction. In some industries, however,
relatively few truly comparable M&A transactions have occurred (or the acquisitions were too small to
have publicized deal details), so the Precedent Transaction analysis maybe be difficult to conduct.
If the buyer acquires a majority stake in a company (or similarly, when a controlling stake in a business
is divested), a Precedent Transaction analysis is almost always the theoretically correct Comparable
Company analysis to perform. Why do we use Precedent Transactions analysis in this scenario? Because
when a majority stake is purchased, the buyer assumes control of the acquired entity. By having control
over the business, the buyer has more flexibility and more options about how to create value for the
business, with less interference from other stakeholders. Therefore, when control is transferred, a
control premium is typically paid.
Precedent Transactions are designed to attempt to ascertain the difference between the value of the
comparable companies acquired in the past before the transaction vs. after the transaction. (In other
words, the analyst determines the difference between the market value of the company before the
transaction is announced vs. the amount paid for the company in a control-transferring purchase.) This
difference represents the premium paid to acquire the controlling interest in the business. Thus when a
change of control is occurring, Precedent Transaction analysis should typically be one of the valuation
methods used.
We will detail the calculation process for Precedent Transaction analysis later in this guide.
LEVERAGE BUYOUT ANALYSIS (LBO)
Another possible way to value a company is via LBO analysis. LBOs are typically used by “financial
sponsors” (private equity firms) who are looking to acquire companies inexpensively in the hopes that
they can be sold at a profit in several years. In order to maximize returns from these investments, LBO
firms generally try to use as much borrowed capital (debt financing) as possible to fund the acquisition
of the company, thereby minimizing the amount of equity capital that the sponsor itself must invest
(equity financing). Assuming that the investment makes a profit, this debt leverage maximizes the
return achieved for the sponsors’ investors.
There are three possible approaches to take in running an LBO analysis for a target company:
1. Assume a minimum required return for the financial sponsor plus an appropriate debt/equity
ratio, and from this impute a company value.
2. Assume a minimum required return for the financial sponsor plus an appropriate company value,
and from this impute the required debt/equity ratio.

3. Assume an appropriate debt/equity ratio and company value, and from this compute the
investment’s expected return.
Usually the first analysis is performed by investment bankers. If the value of the company is unknown
(as is usually the case), then the goal of the LBO exercise is to determine that value by assuming an
expected return for a private equity investor (typically 20-30%) and a feasible capital structure, and
from that, determining how much the company could be sold for (and thereby still allow the financial
sponsor to achieve that required return). If the expected sale price/value of the company is known (for
example, if a bid on the company has been proposed), then the primary goal of performing an LBO
analysis is to determine the best possible returns scenario given that value. (Bankers will often use LBO
analysis to determine whether a higher valuation from private equity investors is possible, again using
the first analysis.)
LBO analysis can be quite complex to perform, especially as the model gets more and more detailed. For
example, different assumptions about the capital structure can be made, with increasing layers of
refinement, to the point where each individual component of the capital structure is being modeled over
time with a host of tranche-specific assumptions and features. That said, a simple, standard LBO model
with generic, high-level assumptions can be put together fairly easily.
Unfortunately, LBO valuations can be highly subject to market conditions. In a poor market
environment (periods of low capital markets activity, high interest rates, and/or high credit spreads for
High Yield bond issuances), this type of transaction is difficult to use. Hence LBO investing is highly
cyclical depending upon market forces.
Check out our Private Equity Training Course for much more detail on conducting LBO analysis.
Valuation Technique Advantages and Disadvantages
Each valuation method naturally has its own set of advantages and disadvantages. Some are more
reliable and accurate, while others are easier to perform, for example. Additionally, some valuation
methods are specifically indicated in certain circumstances. Here are the main Pros and Cons of each
method:

Pro: Market efficiency ensures that trading values for comparable companies serve as a
reasonably good indicator of value for the company being evaluated, provided that the
comparables are chosen wisely. These comparables should reflect industry trends, business risk,
market growth, etc.
Pro: Values obtained tend to be most reliable as an indicator of value of the company whenever a
non-controlling (minority) investment scenario is being considered.

Con: No two companies are perfectly alike, and as such, their valuations generally should not be
identical either. Thus comparable valuation ratios are often an inexact match. Also, for some
companies, finding a decent sample of comparables (or any at all!) can be very challenging. As a
result in Comparable Companies analysis are always running the risk of “comparing apples to
oranges,” never being able to find a true comparable, or simply having an insufficient set of
comparable valuations from which to draw.

Con: Illiquid comparable stocks that are thinly traded or have a relatively small percentage of
floated stock might have a price that does not reflect the fundamental value of that company.
DISCOUNTED CASH FLOW (DCF) ANALYSIS

Pro: Theoretically the most sound method if one is very confident in the projections and
assumptions, because DCF values the individual cash streams (the actual source of the company’s
value) directly.
Pro: DCF method is not heavily influenced by temporary market conditions or non-economic
factors.
Con: Valuation obtained is very sensitive to modeling assumptions—particularly growth rate,
profit margin, and discount rate assumptions—and as a result, different DCF analyses can lead to
wildly different valuations.
Con: DCF requires the forecasting of future performance, which is very subjective, and most of
the value of the company is usually derived from the “terminal value,” which is the set of cash
flows that occurs after the detailed projection period (and is therefore usually projected in a very
simple way).
PRECEDENT TRANSACTION/PREMIUM PAID ANALYSIS

Pro: Generally regarded as the best valuation tool for control-transferring transactions because
the previous transaction has validated the valuation (in other words, a precedent has been
established, whereby a previous buyer has actually paid the amount specified in the precedent
transaction).
Pro: Assuming that the required transaction data is available/public information, precedent
transactions are typically an easy analysis to perform.
Con: The valuation multiples found in prior transactions typically include control premium and
synergy assumptions, which are not public knowledge and are often transaction-specific. These
assumptions are not always achievable by other market participants conducting a new
transaction.
Con: Precedent Transaction valuations are easily influenced by temporary market conditions,
which fluctuate over time. For example, a prior transaction might have been conducted in a more
favorable environment for debt or equity issuance.
LEVERAGE BUYOUT (LBO) ANALYSIS

Pro: An excellent means to establish a “floor” valuation—i.e., an LBO analysis will determine the
amount that a financial buyer (sponsor) would be willing to pay for the company, thereby
determining the value that a strategic bidder will have to exceed.
Pro: LBO valuation is realistic, as it does not require synergies to achieve (financial buyers
usually do not have synergy opportunities).
Con: Ignoring synergies could result in an underestimated valuation, particularly for a well-
fitting strategic buyer.

Con: The valuation obtained is very sensitive to operating assumptions (growth rate, operating
working capital assumptions, profit margins, etc.) and financing cost assumptions (and thus LBO
valuation is dependent upon the quality of the prevailing financing market conditions).
Valuation Building Blocks: Company Value
In order to use the valuation techniques described above, it is important to understand a few core
building blocks of valuation. These concepts will be used in much more detail in later chapters of this
training course, wherein we will walk you through how to conduct these valuations in explicit detail.
There are three common, related terms used to describe the “value” of a company:
Enterprise Value: Represents the total value of a company’s net operating assets. In other
words, “Enterprise Value” is the value of the entire company.
Market Value: Also known as “Market Capitalization” or “Equity Value,” market value
represents the dollar value of a company’s issued shares of common equity. It is calculated by
multiplying shares outstanding by the current stock price.
Book Value: The accounting valuation of the equity. Book Value simply equals Total Assets –
Total Liabilities. Book Value is often called “liquidation value,” because it represents the expected
value of a company’s assets after they are used to pay off all existing liabilities. This generally
assumes, of course, that the company will be ceasing operations.
WHAT IS THE DIFFERENCE BEEN BOOK VALUE AND MARKET VALUE?
Market Value is almost always larger then Book Value for three primary reasons:
Market Value includes future growth expectations while Book Value does not.
Market Value includes brand value and company intangible assets.
Market Value includes value accrued by the company historically through wise managerial
decision making, while Book Value generally does not.
In other words, Book Value is a value arrived at for a company by simply following the rules of standard
accounting based on a company’s past transactions and operations, while Market Value takes into
account all information about a company’s operations, including future expectations.
HOW DO YOU CALCULATE MARKET VALUE AND ENTERPRISE VALUE?

Market Value is calculated based on the number of shares outstanding multiplied by the company’s
current stock price.
Enterprise Value represents the total value of the firm and is found by adding the Net Debt of a
company to Market Value, where Net Debt is simply the company’s Debt outstanding minus excess
Cash on the company’s balance sheet.
WHY IS CASH SUBTRACTED OUT?
Cash is subtracted out of Enterprise Value because excess Cash is considered a non-operating asset. For
example, that Cash often could be used to pay down part of the company’s debt immediately, which
reduces the Enterprise Value of the Company. (Note that the definition of “excess cash” is somewhat
loose, as it refers to cash that is not needed to conduct the operations of the business; a simplifying
assumption in most cases is to count all Cash as excess Cash.)
WHEN SHOULD ENTERPRISE VALUE BE USED?
Enterprise Value should be used for ratios and other calculations that measure the total return to all
capital holders (such as Revenue, Earnings Before Taxes (EBT); Earnings Before Interest and Tax
(EBIT); Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA); Net Operating
Profit After Tax; Operating Cash Flow; etc.), whereas Equity Value should be used for ratios that
measure the total return to shareholders (such as Earnings/Net Income).
Here are a couple of simple examples of how to calculate Enterprise Value based on information
available for a company:
SOLVING FOR ENTERPRISE VALUE, EXAMPLE 1:

Cash: $200
Debt: $400
Equity: $1,600
Enterprise Value = Market Value of Equity ($1,600) + Debt ($400) – Cash ($200) = $1,800.
SOLVING FOR ENTERPRISE VALUE, EXAMPLE 2:

Shares Out.: 1,000
Stock Price: $10
Debt: $5,000
Cash: $1,000

Enterprise Value = Market Value of Equity (1,000 × $10 = $10,000) + Debt ($5,000) – Cash ($1,000) =
$14,000.
←Valuation: A Conceptual Overview Financial Statement Analysis→
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Comparable Company Analysis | Street Of Walls 1/9/22, 0:28

In this chapter we will cover five key topics:
Comparable Company Analysis (aka “Comps”) Overview

Peer Universe
Market Capitalization & Enterprise Value
Historical & Projected Financials

Spread Multiples
Comparable Company Analyses (Comps) Overview
WHAT ARE COMPS?
Comparably Company Analyses, or “Comps”, are a relative valuation technique used to value a
company by comparing that company’s valuation multiples to those of its peers. Typically, the
multiples are a ratio of some valuation metric (such as equity Market Capitalization or Enterprise
Value) to some financial performance metric (such as Earnings/Earnings Per Share (EPS), Sales, or
EBITDA). (An astute reader will note that Sales and EBITDA are enterprise-wide metrics, and thus
should be used with Enterprise Value, while Earnings/EPS is an equity-related metric, and thus
should be used with Market Capitalization.) The basic idea is that companies with similar
characteristics should trade at similar multiples, all other things being equal.
WHY USE COMPS?
Comps are relatively easy to perform, and the data for them is usually relatively widely available
(provided that the comparable companies are publicly traded). Additionally, assuming that the
market is efficiently pricing the securities of other companies, Comps should provide a reasonable
valuation range, while other valuation methods such as DCF are dependent upon an entire array of
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assumptions.
These factors make Comps one of the most widely-used valuation techniques in practice. Investment
bankers, sell-side research analysts, private equity investors, and other market analysts all use
Comps. They do have their disadvantages, however.
COMPS ADVANTAGES AND DISADVANTAGES
PROs and CONs of Using Comps
PROs CONs
Easy to calculate using widely available Influenced by temporary market

data conditions or non-fundamental factors
Easy to communicate across a variety of Not useful when there are few or no
market participants comparable companies
Determine a benchmark value for Can be difficult to find appropriate
multiples used in valuation comparable companies for various
Provide a useful way to assess market reasons
assumptions of fundamental Less reliable when comparable
characteristics baked into valuations companies are thinly traded
Performing a Comparable Companies Analysis
REMEMBER C.V.S.
When doing a Comps analysis, a useful checklist of things to do has a mnemonic that is easy to
remember: “C.V.S.”
Confirm relevant peer universe.

Validate key fundamental metrics.
Select appropriate multiple for valuation.
The appropriate selection of a relevant peer universe is critical for a Comps analysis, because it plays
a significant role in the valuation of the target company. For example, a company could sometimes
be compared across two different industries due to the nature of the business (e.g. an internet retail
company). Similarly, some comparable companies might need to be ruled out or adjusted because it
owns businesses across several different industry groups. Peer universe selection is therefore
somewhat subjective.
When doing a Comps valuation, the analyst can choose to use either trailing (historical)
performance metrics, or future (forecast) performance metrics. (Note that many analyses will look at
both historical and future metrics.) In general future metrics are preferred, but one needs to be
careful with this. For example, projected EBITDA and projected Earnings/EPS are subject to all
kinds of potential pitfalls associated with forecasting. The forecast numbers may end up being
significantly off.
Additionally, when performing a Comps analysis you may want to adjust the performance for
various one-time charges and non-recurring items (such as a sale of assets, a one-time legal
expense, or a restructuring charge). It is important that all companies in the analysis use “clean”
numbers to provide an “apples-to-apples” comparison. This becomes especially difficult when using
future performance metrics, as the non-recurring items may be as-yet unknown.
KEY ASSUMPTIONS & PROJECTIONS:
To quickly recap on key assumptions and projections that we need to make when performing a
Comps analysis:
Peer Universe: A selection of competitor/similar companies used to determine a

benchmark valuation.
EBITDA: Historical & projected Earnings before Interest, Taxes, Depreciation &
Amortization.
EPS: Historical & projected Earnings Per Share.
TYPES OF MULTIPLES
There are various types of multiples that can be used in a Comps analysis. In general, multiples can
be classified in two broad categories: Operating multiples and Equity multiples. Operating
multiples refer to the operating results of the business as a whole while Equity multiples refer to the
value created from the company that is available to equity/shareholders.
Typical multiples for Comps include:
EV/Sales: The Enterprise value of the company divided by Sales/Revenue (Operating

multiple)
EV/EBITDA: The Enterprise value of the company divided by EBITDA (Operating multiple)
P/E: Price/Earnings ratio for a company (Equity multiple). This is either calculated as Share
Price ÷ EPS, or Market Capitalization ÷ Earnings (they are mathematically equivalent).
P/B: Price/Book ratio for a company (Equity multiple). This is either calculated as Share
Price ÷ Book Value per Share, or Market Capitalization ÷ Shareholders’ Equity (they are
mathematically equivalent).
P/(Levered) Cash Flow: Price/Cash Flow ratio for a company (Equity multiple). This is
either calculated as Share Price ÷ Levered Cash Flow per Share, or Market Capitalization ÷
Levered Cash Flow (they are mathematically equivalent).
Note that for Operating Multiples we use Enterprise Value as the numerator of the calculation, while
for Equity Multiples, we use Market Capitalization as the numerator. You should generally not use
EV for equity-related performance metrics, nor should you use Market Capitalization for enterprise-
related performance metrics.
RECAP ON OPERATING MULTIPLES:
The most commonly used Operating multiples are EV/Sales and EV/EBITDA.
Operating multiples ignore financial leverage (Debt) and typically ignore Depreciation &
Amortization.
They value the total company versus common stock (Equity) only.
They are frequently used by investment bankers, private equity investors.
RECAP ON EQUITY MULTIPLES:
The most commonly used Equity multiples are P/E, P/B, and P/Cash Flow (Levered).
Equity multiples ignore cash flow to Debt holders.
They are frequently used by investment bankers and equity analysts.
In this training course, the two most common multiples, EV/EBITDA (an Operating multiple) and
P/E (an Equity multiple), will be used. However, it is still worthwhile to be aware of other kinds of
multiples, as they are frequently used.
WHEN ARE PRICE/SALES MULTIPLES USED?
Price/Sales multiples are typically used for companies with negative, highly volatile, or abnormally
high/low EPS. For example, fast-growing companies that have no earnings yet or negative earnings
(because they are spending a lot of money to grow or have not yet reached critical mass for sales)
may be valued based upon multiples of Sales. A common advantage of using Price/Sales is the
general stability and lower accounting distortion afforded by sales numbers. However, sales
numbers can be manipulated through revenue recognition practices and growth companies can be
given high valuations regardless of having no earnings or cash flow. Additionally, using Sales as a
basis for valuation does not take into account the profitability of those Sales figures. Some
companies, for example, may be able to turn a large profit margin on incremental sales, while others
might have very narrow profit margins.
WHEN ARE PRICE/BOOK MULTIPLES USED?
Price/Book multiples are often used to value financial services companies since their balance sheets
are primarily composed of liquid assets that often approximate market values. These multiples can
also be used for companies with no earnings, highly variable earnings or companies not expected to
continue as a going concern. Unfortunately, for most companies in most industries the Price/Book
ratio is highly idiosyncratic, because the Book Value is a function of all past business activities
(literally since the company’s founding or most recent recapitalization). Therefore Price/Book ratios
can swing wildly depending on each company’s circumstances.
WHAT ARE CASH FLOW MULTIPLES?
Cash Flow multiples use an estimate of Cash Flow, such as EBITDA, Operating Cash Flow, Free Cash
Flow, and Levered Free Cash Flow, as a valuation indicator. These multiples are often superior to
Earnings multiples because they ignore a lot of the idiosyncrasies of accrual-based accounting and
are therefore less subject to management manipulation. (Note that EBITDA ignores Capital
Expenditures, which are indeed a Cash outflow. Thus in many instances Comps will use (EBITDA –
Capital Expenditures) as the Cash Flow estimate.)
Many times in practice, the reciprocal of these multiples are used to produce Cash Flow Yields,
which are compared against treasury yields and dividend yields as a valuation yardstick.
PITFALLS TO AVOID WHEN USING COMPS
Avoid these typical pitfalls when building a Comps analysis:
Inappropriate peer universe selected

One-off and recurring items included in historical/projected EBITDA and EPS
Wrong multiple selected for valuation
Again, remember the mnemonic, “C.V.S.”
Confirm relevant peer universe.

Validate key fundamental metrics.
Select appropriate multiple for valuation.
STEPS TO REMEMBER FOR EXECUTING A COMPS VALUATION
1. Select a Peer Universe: Pick a group of competitor/similar companies with comparable

industries and fundamental characteristics.
2. Calculate Market Capitalization: It is equal to Share price × Number of Shares
Outstanding.
3. Calculate Enterprise Value: Market Capitalization + Debt + Preferred Stock + Minority
Interest (less common) – Cash.
4. Historical & Projected Financials: Use historical financials from filings and projections
from management, sell-side equity analysts, etc.
5. Spread Multiples: Using Market Capitalization, Enterprise Value and historical/projected
financials, spread (i.e., calculate) EV/EBITDA and P/E multiples.
6. Value Target Company: Pick the appropriate benchmark valuation multiple for the peer
group, and value the target company based on that multiple. Typically, an average or median
is used.
SOURCES OF INFORMATION NEEDED FOR COMPS
Peer Universe: Company filings, Research Reports, Bloomberg, or FactSet

Historical Financial Results: SEC.gov has company annual reports (10-K), Quarterly
reports (10-Q), and (where available) investor Prospectuses.
Financial Projections: Management estimates, sell-side equity analyst estimates, and/or
internal estimates generated by the bank
Peer Universe
In order to spread (calculate) comps, you must find similar companies that operate in the same
industry as the company you are trying to value.
Once again, remember “C.V.S.”: Confirm relevant peer universe. Validate key fundamental
metrics. Select appropriate multiple for valuation.
PICKING A PEER UNIVERSE
Choosing a relevant peer universe for valuation is usually done in one of two ways:
1. Your investment banking deal team or Managing Director (MD) will instruct you as to which
comparable companies to use. For example, the MD might say, “Use the following 10
companies in this analysis.” The Management team of the company usually has the best
insight into the true competition in the marketplace, and is therefore usually the best
resource, but it is the job of investment bankers to figure this out on their own.
2. Run a search using bank resources (such as Bloomberg, FactSet, and Analyst Reports; see
below) and screen the result set for relevance.
WHAT RESOURCES CAN BE USED TO FIND PEERS?
Some of the best resources include the following:
Company Filings: A primary source for finding peer companies is in company filings (10Ks,
10Qs, Prospectuses) in the “Competitors” section. These filings can be found at the SEC
website (http://www.sec.gov/).
Sell-side Equity Analyst Research Reports: Sell-side research reports are an excellent
source of comparable companies. Usually, an initiation report or a lengthy industry report will
have a fairly complete list of peer companies. This provides a good point of reference for what
other Wall Street analysts believe to be the target company’s relevant peer universe.
Bloomberg: A very useful tool for finding peers is the Supply Chain page on Bloomberg for a
given company. To use this tool, type <<Ticker>> Equity SPLC <GO>. The page provides a
quick snapshot of a company’s suppliers, customers and peers. Below is an example sample
screen shot for Apple Corporation (AAPL). The peer companies are shown at the bottom of
the page. The suppliers and customers should also be examined for possible inclusion in the
peer universe:
It is important to note that you will almost never find a perfect comparable company, because
companies are very similar to snowflakes—no two are ever exactly alike. However, you will be able to
narrow down your search using the characteristics such as Sector, Products & services sold,
Customer base, Distribution channel, and Geography. Some examples of nearly perfect comparable
companies are: Pizza Hut and Domino’s, Home Depot and Lowe’s, or Pepsi and Coca-Cola. These
are very similar (not identical!) companies that overlap very well in terms of all of the relevant
factors: geography, products/services, customers, and distribution channel.
Market Capitalization (Market Value) & Enterprise Value
Once you have selected a relevant peer universe, the next step is to find the necessary financials to
spread (calculate) your multiples. Bankers will typically use database resources such as Capital IQ
and FactSet in order to pull this information quickly. This should be checked against the actual
GAAP data released in company 10-Qs and 10-Ks filed with the SEC, because these datasets often
include errors or questionable assumptions/adjustments. (In that respect, it often is best to gather
the data from the SEC directly when running a comparables analysis.)
Necessary financials typically include the following information:
Market Capitalization (Stock Price × Shares Outstanding)

Enterprise Value (Market Value + Net Debt + Preferred Stock + Minority Interest – Cash)
Earnings per Share (EPS, Net Income ÷ Shares Outstanding)
Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA)
Here is an example of a final output from a Comps Analysis. The key financial inputs to this analysis
will then be discussed:
MARKET CAPITALIZATION (MARKET VALUE)
Market Capitalization represents the total equity value of a company, and does not reflect
management’s allocation of capital structure among all forms of financing (such as equity, debt,
preferred stock, etc.). It is a useful representation of valuation for common stock investors because
they typically do not purchase a majority-owned stake in the company, and therefore only have
access to the earnings available to common shareholders.
The formula for calculating Market Capitalization is:
Market Capitalization = Stock Price × Shares Outstanding
Stock price is the price per common share. It is obtained using any financial software (Thomson,
Bloomberg, CapIQ) or reliable Internet pricing service (Yahoo Finance, Google Finance). (Be sure to
verify that price is the closing price as of the analysis date.)
There are two types of Shares Outstanding: Basic and Diluted. Basic shares outstanding can be
obtained from the first page of a company’s 10-K or 10-Q. Diluted shares outstanding account for
the conversion of options, warrants and convertible preferred stock and prevents a possible
underestimate of valuation caused by using basic shares outstanding. Diluted shares outstanding
can be obtained from the EPS footnotes of a company’s financials, and can also be calculated directly
using footnotes to the financials that list management stock options as well as warrants and
convertible preferred stock.
ENTERPRISE VALUE
Enterprise Value (EV) represents the total value of a company and incorporates all of the
components of management’s allocation of the capital structure–equity, debt, preferred stock, etc. It
is a useful representation of valuation for strategic and private equity investors because it represents
the takeover value of the company (prior to any control premium for the acquisition).
The formula for calculating EV is:
EV = Market Capitalization + Debt + Preferred Stock + Minority Interest – Cash
Let’s look briefly at what each of these components of EV refer to and how they are calculated.
MARKET CAPITALIZATION
Market Capitalization, as defined earlier (Stock Price × Shares Outstanding), refers to the
total equity value of the company.
It can be defined using Basic shares outstanding or Diluted shares outstanding.
DEBT
Includes short and long-term debt, as listed on the company’s balance sheet, as well as
current portions of long-term debt (listed in the Current Liabilities section of balance sheet).
Each line item of debt will generally be footnoted with specific terms of the debt arrangement
given.
PREFERRED STOCK
Listed in the Equity section of the balance sheet, Preferred Stock is a special tranche of the
capital structure that has some debt-like qualities (like paying interest) and some equity-like
qualities (often convertible into shares, and sometimes has voting rights alongside common
equityholders).
Only include: mandatorily redeemable and convertible preferred where conversion price >
stock price.
MINORITY INTEREST (WHAT IS IT AND WHY DO WE INCLUDE IT?)
Minority interest is the equity interest that other entities have in a division (subsidiary) of the
company. This will occur whenever the company owns more than 50% but less than 100% of
the equity in a subsidiary. The company has control over the subsidiary, but doesn’t own all of
it.
These subsidiaries will have financial results that are fully consolidated into the company’s
financial results. Therefore, financial results such as Sales, EBITDA, Earnings, etc. that are
attributable to other owners will be included in the valuation metrics. The numerator of the
calculation should therefore include these minority stakes in the subsidiaries as well.
For accounting purposes, Minority Interest is treated as a liability on the Balance Sheet and
this liability amount should be added into the EV calculation.
WHY IS CASH DEDUCTED IN THE ENTERPRISE VALUE CALCULATION?
Cash is subtracted out of Enterprise Value because excess Cash is considered a non-operating
asset, and could be used to pay down part of the company’s debt immediately, which would
reduce the Enterprise Value of the Company. (Note that the definition of “excess cash” is
somewhat loose, as it refers to cash that is not needed to conduct the operations of the
business; a simplifying assumption in most cases is to count all Cash as excess Cash.)
Historical & Projected Financials
Two fundamental metrics will always need to be calculated and input into the analysis before the
Comps can be spread: 1) EPS and 2) EBITDA. These form the denominators of the multiples used in
the analysis. Each of the examples given below consist of a historical financial result (2011 in this
example) and projected (2012E & 2013E) financial result.
HISTORICAL EPS
Historical EPS can be obtained directly from a company’s income statement in the 10-K, 10-Q or
most recent earnings press release. Note, however, that Historical EPS will often need to be adjusted
for non-recurring items such as one-off charges (e.g. restructuring), extraordinary gains/losses, etc.
Often, management details adjustments in company press releases. These press releases can be
found in the Investor Relations section of company website, or via footnotes or the Management
Discussion & Analysis (MD&A) section of 10-K and 10-Q filings.
These items need to be added on a pre-tax basis for “above-the-line items” (items that appear before
the Taxes line item in financial statements, such as Revenue, Gross Profit, and Operating Profit). If
the adjustment is to a “below-the-line” item, use the effective tax rate to determine the relevant pre-
tax amount. For adjustments to Net Income, use the effective tax rate on all pre-tax items to
determine the appropriate after-tax amount.
PROJECTED EPS
Projected EPS can be derived in several different ways:
Management estimates
Consensus analyst estimates from aggregators such as Thomson One, Capital IQ or Zacks
Individual sell-side research analysts
Your own financial model (this is rare for an initial cut at a Comparable Companies Analysis)
EBITDA
EBITDA is calculated using the following formula:
EBITDA = EBIT (Operating Profit) + Depreciation + Amortization
Spread Multiples
The next step after collecting the relevant peer universe and locating the necessary financials for
each peer is to start “spreading” the key trading multiples—in other words, calculating and
displaying them in an easy-to-read fashion, typically in a spreadsheet. This approach allows users to
easily see the valuation calculations across your custom-defined peer universe.
The Comps table should include Mean, Median, Min and Max statistics for each metric in each year
to provide a valuation range for the company you are valuing.
VALUE TARGET COMPANY
The final step, once multiples for the peer universe have been spread, is to use this information to
determine valuation. With the valuation metrics calculated as described, we can use the multiples of
the peer universe to determine the valuation of the target company.
Let’s look at an example:
COMPANY F HAS AN ESTIMATED EPS OF $1.50 IN 2012. HOW MUCH IS ITS STOCK WORTH USING
THE COMPS GIVEN?
The calculation is as follows:
The Comps set given is trading at 12.4x (median) 2012E Earnings Per Share.
12.4 × $1.50 = $18.60. (P/E multiples gives us Market Value Per Share, so we are finished!)
COMPANY F HAS AN ESTIMATED EBITDA OF $77 (MILLION) IN 2012. HOW MUCH IS ITS STOCK
WORTH USING THE COMPS GIVEN?
The calculation is as follows:
The Comps set given is trading at 5.4x (median) 2012E EBITDA.
5.4 × $77 million = $415.8 million. (This is the Enterprise Value; we need to back out Net
Debt to get to Market Capitalization. The difference between the EV and Mkt. Cap. given for
Company F must equal Net Debt.)

$415.8 million – ($417 million – $422 million) = $415.8 million + $5.0 million = $420.8
million. (This is Market Capitalization; we need to divide by Shares Outstanding to get the
Share Price.)
$420.8 million ÷ 30.2 million = $13.93.
VALUATION CONCLUSION
Based on comparable company analysis, Comp F is worth between $13.93 – $18.60 based
on 2012E P/E and EBITDA multiples of public competitors.
←Financial Statement Analysis Discounted Cash Flow Analysis→
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Discounted Cash Flow Analysis | Street Of Walls 1/9/22, 0:29
DISCOUNTED CASH FLOW ANALYSIS

In this Discounted Cash Flow chapter, we will cover four key topics:
Discounted Cash Flow (DCF) Overview

Free Cash Flow
Terminal Value
WACC (Weighted Average Cost of Capital)
Discounted Cash Flow (DCF) Overview
WHAT IS DCF?
DCF is a direct valuation technique that values a company by projecting its future cash flows and
then using the Net Present Value (NPV) method to value those cash flows. In a DCF analysis, the
cash flows are projected by using a series of assumptions about how the business will perform in the
future, and then forecasting how this business performance translates into the cash flow generated
by the business—the one thing investors care the most about.
NPV is simply a mathematical technique for translating each of these projected annual cash flow
amounts into today-equivalent amounts so that each year’s projected cash flows can be summed up
in comparable, current-dollar amounts.
WHY USE DCF?
DCF should be used in many cases because it attempts to measure the value created by a business
directly and precisely. It is thus the most theoretically correct valuation method available: the value
of a firm ultimately derives from the inherent value of its future cash flows to its stakeholders.
https://www.streetofwalls.com/finance-training-courses/investment-banking-technical-training/discounted-cash-flow-analysis/ Página 1 de 21
DCF is probably the most broadly used valuation technique, simply because of its theoretical
underpinnings and its ability to be used in almost all scenarios. DCF is used by Investment Bankers,
Internal Corporate Finance and Business Development professionals, and Academics.
However, DCF is fraught with potential perils. The valuation obtained is very sensitive to a large
number of assumptions/forecasts, and can therefore vary over a wide range. If even one key
assumption is off significantly, it can lead to a wildly different valuation. This is quite possible, given
that DCF involves predicting future events (forecasting), and even the best forecasters will generally
be off by some amount. This leads to the concept of “Garbage in = Garbage Out”—if wrong
assumptions are made, the result will be wrong.
Additionally, DCF does not take into account any market-related valuation information, such as the
valuations of comparable companies, as a “sanity check” on its valuation outputs. Therefore, DCF
should generally only be done alongside other valuation techniques, lest a questionable assumption
or two lead to a result that is substantially different from what market forces are indicating.
DCF ADVANTAGES AND DISADVANTAGES
PROs and CONs of Using DCF
PROs CONs
Theoretically the most sound

method if the analyst is confident Valuation obtained is very sensitive to a large
in his assumptions number of assumptions/forecasts, and can thus
Not significantly influenced by vary over a wide range
temporary market conditions or Often very time-intensive relative to some other

non-economic factors valuation techniques
Especially useful when there is Involves forecasting future performance, which
limited or no comparable is very difficult
information
REMEMBER C.V.S.
When doing a DCF analysis, a useful checklist of things to do has a mnemonic that is easy to
remember: “C.V.S.”
Confirm historical financials for accuracy.

Validate key assumptions for projections.
Sensitize variables driving projections to build a valuation range.
Note that the “C.V.S.” acronym for Comparable Companies Analysis, discussed in the previous
chapter, is slightly different (in that acronym, “S” stands for “Select” rather than “Sensitize.”)
KEY ASSUMPTIONS & PROJECTIONS:
When performing a DCF analysis, a series of assumptions and projections will need to be made.
Ultimately, all of these inputs will boil down to three main components that drive the valuation
result from a DCF analysis.
Free Cash Flow Projections: Projections of the amount of Cash produced by a

company’s business operations after paying for operating expenses and capital expenditures.
Discount Rate: The cost of capital (Debt and Equity) for the business. This rate, which acts
like an interest rate on future Cash inflows, is used to convert them into current dollar
equivalents.
Terminal Value: The value of a business at the end of the projection period (typical for a
DCF analysis is either a 5-year projection period or, occasionally, a 10-year projection period).
The DCF valuation of the business is simply equal to the sum of the discounted projected Free Cash
Flow amounts, plus the discounted Terminal Value amount.
There is no exact answer for deriving Free Cash Flow projections. The key is to be diligent when
making the assumptions needed to derive these projections, and where uncertain, use valuation
technique guidelines to guide your thinking (some examples of this are discussed later in the
chapter). It is very easy to increase or decrease the valuation from a DCF substantially by changing
the assumptions, which is why it is so important to be thoughtful when specifying the inputs.
The Discount Rate is usually determined as a function of prevailing market (or known) required
rates of return for Debt and Equity, as well as the split between outstanding Debt and Equity in
the company’s capital structure. These required rates of return (or discount rates or “costs of
capital”) are generally then blended into a single discount rate for the Free Cash Flows of the
company as a whole—this is known as the Weighted Average Cost of Capital (WACC). We will
discuss WACC calculations in detail later in this chapter.
Terminal Value is the value of the business that derives from Cash flows generated after the year-
by-year projection period. It is determined as a function of the Cash flows generated in the final
projection period, plus an assumed permanent growth rate for those cash flows, plus an assumed
discount rate (or exit multiple). More is discussed on calculating Terminal Value later in this
chapter.
TWO DIFFERENT DCF APPROACHES: LEVERED VS. UNLEVERED CASH FLOWS
There are two ways of projecting a company’s Free Cash Flow (FCF): on an unlevered basis, or on a
levered basis.
A levered DCF projects FCF after Interest Expense (Debt) and Interest Income (Cash) while an
unlevered DCF projects FCF before the impact on Debt and Cash. A levered DCF therefore attempts
to value the Equity portion of a company’s capital structure directly, while an unlevered DCF
analysis attempts to value the company as a whole; at the end of the unlevered DCF analysis, Net
Debt and other claims can be subtracted out to arrive at the residual (Equity) value of the business.
An Unlevered DCF involves the following steps:
Project FCF for each year, before the impact from Debt and Cash.
Discount FCF using the Weighted Average Cost of Capital (WACC), which is a blend of the
required returns on the Debt and Equity components of the capital structure.
Value obtained is the Enterprise Value of the business.
By comparison, a Levered DCF involves the following steps:
Project FCF after Interest Expense (to Debt) and Interest Income (from Cash).
Discount FCF using the Cost of Equity (the required rate of return on Equity).
Value obtained is the Equity Value (aka Market Value) of the business.
WHY USE UNLEVERED FREE CASH FLOW (UFCF) VS. LEVERED FREE CASH FLOW (LFCF)?
UFCF is the industry norm, because it allows for an apples-to-apples comparison of the Cash flows
produced by different companies. A UFCF analysis also affords the analyst the ability to test out
different capital structures to determine how they impact a company’s value. By contrast, in an
LFCF analysis, the capital structure is taken into account in the calculation of the company’s Cash
flows. This means that the LFCF analysis will need to be re-run if a different capital structure is
assumed.
In effect, UFCF allows the analyst to separate the Cash flows produced by the business from the
structure of the ownership and liabilities of the business. In a UFCF the Cash flows of the business
are projected irrespective of the capital structure chosen in a UFCF analysis; the exact capital
structure is not taken into account until the Weighted Average Cost of Capital (WACC) is
determined.
WHICH IS MO
MORE
RE SENSITIVE PART OF A DCF MODEL: FREE CASH FLOWS OR DISCOUNT RATE?
FCF (and Terminal Value, which uses FCF as an input) are the more sensitive. Be careful, therefore,
when making key Cash flow projection assumptions, because a small ‘tweak’ may result in a large
valuation change. The analyst should test several reasonable assumption scenarios to derive a
reasonable valuation range. Within FCF projections, the best items to test include Sales growth and
assumed margins (Gross Margin, Operating/EBIT margin, EBITDA margin, and Net Income
margin). Also, sensitivity analysis should be conducted on the Discount Rate (WACC) used.
DCF PITFALLS
Avoid these common pitfalls when building a DCF Model:
Making important assumptions based upon insufficient research.
Lack of footnotes and details documenting the thought process (and research process) behind
the assumptions chosen.
Taking an improper approach to deriving the Costs of Capital for Debt and/or Equity (and/or
WACC).
DCF STEPS
1. Project the company’s Free Cash Flows: Typically, a target’s FCF is projected out 5 to 10
years in the future. The further these numbers are projected out, the less visibility the
forecaster will have (in other words, later projection periods will typically be subject to the
most estimation error).
2. Determine the company’s Terminal Value: Terminal Value is calculated using one of
two methods: the Terminal Multiple Method or the Perpetuity Method. (Note that if
the Perpetuity Method is used, the Discount Rate from the following step will be needed.)
3. Determine the company’s Discount Rate: Calculate the company’s Weighted Average
Cost of Capital (WACC) to determine the Discount Rate for all future Cash flows.
4. Use Net Present Value: Discount the projected FCF and Terminal Value back to Year o
(i.e., back to today) and sum these figures to determine the Enterprise Value of the company.
5. Make Adjustments: If using an Unlevered Free Cash Flow (UFCF) approach, subtracting
out net debt and other adjustments from Enterprise Value to derive the Market Value of the
company.
Here is a graphical representation of these DCF Steps:
SOURCES OF DCF INFORMATION
In order to project a company’s future Cash flows reasonably well, the analyst will need to take into
account as much known information about the company (and several market metrics) as possible.
The following sources can help provide needed information to produce a high-quality DCF analysis:
Historical Financial Results:

The SEC (http://www.sec.gov/) has company Annual Reports (10-K), Quarterly
Reports (10-Q), and Investment Prospectuses (where available).
Cost of Debt:
Use a weighted average of the Debt interest rates in a company’s capital structure
to calculate the company’s pre-tax Cost of Debt.
This information is almost always available for each Debt instrument in a
Company’s Annual Reports (10-K) and Quarterly Reports (10-Q).
Cost of Equity:
The Risk Free Rate:
The risk-free rate is needed in determining the Cost of Equity, and is
estimated as a function of the current long-term Treasury Bond rate
(assuming that the company’s cash flows are being projected in terms of
US$). The benchmark rate used is generally that of the 10-year bond.
The Department of the Treasury (http://www.treasury.gov/) publishes
U.S. treasury bond rates on a daily basis.
For European companies, use the relevant rate from Euro-denominated
government bonds.
Beta :
Beta is a measure of the relationship between changes in the prices of a
company’s securities and changes in the value of an overall market
benchmark, such as the S&P 500 index.
Bloomberg, FactSet, Google Finance, and Capital IQ all publish historical
and estimated Beta figures for individual stocks. If the Beta is not
published, it can be estimated by means of a simple linear regression.
Market Risk:
The Market Risk Premium is a measure of the degree to which investors
expect to be compensated for owning risky equity securities, rather than
risk-free, fixed-rate investments (such as in government bonds). It is
calculated using the Capital Asset Pricing Model, which assumes that the
ONLY source of risk that demands compensation is overall market risk (as
measured by Beta) rather than idiosyncratic (or stock-specific) risk. This
model is generally used to determine the Cost of Equity for a company.
Estimates of the Market Risk Premium are available from Morningstar,
and can also be estimated using historical returns on government bond
investments vs. overall equity market investments.
Financial Projections:
Management Estimates can be a useful starting point for determining a company’s
expected performance and Cash flow projections. However, keep in mind that these
projections are often on the optimistic side.
Sell-side Research Estimates also can provide useful insight into a company’s path of
expected performance. Again, however, keep in mind that sell-side analysts often have
an incentive to be optimistic in projecting a company’s expected performance.
Internal Estimates (from the investment bank you work for) can be the most useful
source of information for projecting a company’s expected Cash flow—particularly if
these estimates were not used as part of a sell-side advisory engagement (wherein the
purpose of the analysis would be, at least in part, to advocate for a higher selling price
for the client). If using internal estimates, be sure to note how they were generated and
for what purpose.
Free Cash Flow (FCF)
In projecting Free Cash Flow for a business, remember “C.V.S.”, and that Garbage In = Garbage
Out:

In order to calculate Free Cash Flow projections, you must first collect historical financial results.
KEY INPUTS TO FREE CASH FLOW (FCF)
Free Cash Flow (FCF) is calculated by taking the Operating Income (EBIT) for a business, minus its
Taxes, plus Depreciation & Amortization, minus the Change in Operating Working Capital, and
minus the company’s Capital Expenditures for the year. This derives a much more accurate
representation of the Cash that a company generates than does pure Net Income:
PROJECTING FREE CASH FLOW (FCF)
KEY ASSUMPTIONS IN PROJECTING BUSINESS PERFORMANCE
The projected FCF in the nearest-out years (Year 1, Year 2, etc.) will have the most impact on a
company’s DCF valuation. The good news is that these Cash flow figures are the least difficult to
project, because the closer we are to an event, the more visibility we have about that event. (The bad
news, of course, is that any error in projecting these figures will have a large impact on the output of
the analysis.)
FCF is derived by projecting the line items of the Income Statement (and often Balance Sheet) for a
company, line by line. As a result, the FCF results are sensitive to a variety of assumptions about the
future operations of the company’s business, including the following:
Income Statement Items:

Revenue (Sales) Growth: Year-over-year growth projections are the most common
mechanism, but the more granularity used, the better. For example, being able to
project out unit growth and pricing per unit is better than a simple year-over-year
growth projection for the Sales number as a whole.
Margins: Project Gross Margin and Operating (EBIT) Margin based on historical
patterns. Consider inputs like commodity costs in Gross Margin and SG&A (Sales,
General, and Administrative) expenses for Operating Margin.
Balance Sheet & Statement of Cash Flow Items:
Capital Expenditures (CapEx): Consider both Expansion CapEx and Maintenance
CapEx. The difference delineates company costs associated with buying new fixed
assets to facilitate growth in the business (Expansion CapEx) from company costs
associated with adding to/maintaining the value of existing assets required to service
existing business (Maintenance CapEx). Unfortunately, this breakdown is generally
unavailable in a company’s financial reports.
Changes in Operating Working Capital (OWC): Operating Working Capital is
equal to Current Assets minus Current Liabilities, excluding Cash, Cash-like items
(such as Marketable Securities and Securities Available for Sale), and Debt. It can be
found by incorporating the relevant line items from the Balance Sheet. Use historical
patterns and common sense to evaluate this line item—most OWC items are driven by
Sales of the company. Thus, growth in these items should at least to some extent be a
function of Sales growth.
Remember “C.V.S.” when projecting all of these items. The assumptions driving these projections
are critical to the credibility of the output.

PROJECTING BUSINESS PERFORMANCE
As mentioned, we first project the company’s Income Statement. Below, we will walk you through a
simple example of how to do this.
Revenue: For simplicity, Revenue in our example is projected out at an annual growth rate
of 10%, which is in-line with historical growth rates of the hypothetical company. In order to
increase accuracy for this assumption, remember to study management projections, sell-side
projections, and internal estimates. Also remember that more granularity, where possible, is
better.
Cost of Goods Sold (COGS): As Revenue grows, we increased the gross profit margin by
shrinking COGS as a percentage of Revenue because of the concept of economies of scale at
the company (as the company grows it should experience at least some improved utilization of
existing equipment and human resources, increased purchasing power, increased pricing
power, etc.). Also note that for the purposes of this simple example, we are excluding
Depreciation from COGS. In many cases, we would include it and back it out later.
Selling, General, & Administrative (SG&A): Kept constant as a percentage of Revenue

(14.5%) in this example, as the company will need to increase advertising and overhead in
order to drive Sales growth. In some cases, some portion of SG&A can be considered fixed
(such as Corporate Headquarters costs), which may lead to diminishing SG&A expenses as a
percentage of Sales as the company grows.

EBITDA: This is a direct output of our Revenue and cost assumptions. Had we incorporated
Depreciation into expenses, we would need to add it back to Operating Income (EBIT) to
arrive at EBITDA.
DEPRECIATION AND CAPITAL EXPENDITURES
Depreciation is a non-Cash expense, meaning the company books Depreciation as an expense on the
income statement for GAAP (Generally Accepted Accounting Principles) purposes but in reality, no
Cash was actually spent. It is an expense of Capital Expenditures made in prior years. Therefore, in
order to calculate true “Cash flow,” this must be added this back. Similarly, CapEx must be
subtracted out, because it does not appear in the Income Statement, but it is an actual Cash expense.
It should be noted that Amortization acts in much the same way as Depreciation, but is used to
expense non-Fixed Assets rather than Fixed Assets. An example of this would be Amortization on
the value of a patent purchased when acquiring a company that owned it.
BUILDING UP TO UNLEVERED FREE CASH FLOW
The next step is to take our business performance projections and calculate Unlevered FCF (UFCF)
in each year:
Tax-adjusted EBIT: D&A needs to be taken out of EBITDA in order to calculate after-tax
Operating Profit (aka EBIT). D&A is an expense for tax purposes. Thus, first we must subtract
D&A in this model to calculate taxes, and then add it back after taxes. In this case, it is
projected as 5.1% of Sales.

Tax Rate: Use last twelve months (LTM, also referred to as trailing twelve months, or TTM)
tax rate in order to project future tax rates. In this case, 35% is used.
Depreciation & Amortization (D&A): D&A was initially taken out to calculate taxes but
then added back, because it is a non-cash expense. Capital Expenditures (CapEx):

Subtracted out, as this represents Cash needed to fund new and existing assets. It is not
expensed on the Income Statement, as these purchased assets will be used to support
operations in upcoming years for the business (and is thus gradually expensed, via
Depreciation, in those years). Note that net of inflation, CapEx and Depreciation should
converge over time, provided that the company is not growing rapidly.
Change in Operating Working Capital (OWC): This is subtracted out, as it represents

investments in short-term net operating assets needed to fund Revenue growth. This figure
represents the annual change in Current Assets minus Current Liabilities on the Balance
Sheet, excluding Cash, Cash-like items, and Debt.
Now we can apply the formula:
UFCF = Tax-adjusted EBIT + D&A – CapEx – Change in OWC
DISCOUNTING THE UFCF FIGURES
We have now projected the expected Unlevered Free Cash Flows (UFCF) in each of the upcoming
years. However, to value the company, we have to discount those cash flows into equivalent current
(today’s) dollars. This is where Net Present Value (NPV) comes in.
The formula for calculating Present Value (PV) is as follows:
In this formula, the PV is equal to the FCF in each year (Year 1, Year 2, Year 3, etc.), divided by a
discount factor. In each case, the discount factor is 1 + the discount rate (r), taken to the nth
power, where n is the number of years into the future that the Cash flow is occurring (similar to the
compounding of an annual interest rate).
We will go into more detail on determining the discount rate, r, in the WACC section of this chapter.
The difference between Present Value and Net Present Value is simply to incorporate any cash
outflows that might occur in the scenario. Since a DCF analysis involves only the cash inflows from a
company’s operations, Present Value and Net Present Value are equivalent.
Terminal Value
Terminal Value represents the value of the cash flows after the projection period. Projections only
go out so far in the DCF (i.e. 5 or 10 years), so this is a mechanism for estimating the future value of
the business’s cash flows after that projection period.
The Terminal Value is based on the cash flows of the business in a normalized environment. What
this means is that the business should be assumed, after the projection period, to grow at a rate that
is appropriate for a business of its type at the end of the projection period, and/or to be valued at
multiples consistent with those of its peers (see the chapter on Comparable Companies Analysis
earlier in this training course).
CALCULATING TERMINAL VALUE
There are two primary methods to compute a company’s terminal value:
1. Terminal Multiple Method: Also referred to as the Exit Multiple Method, this technique
uses a multiple of a financial metric (such as EBITDA) to drive a business’s valuation. These
multiples can be derived using multiples prevalent among comparable companies.

2. Perpetuity Method: Assumes that the Free Cash Flows of the business grow in perpetuity
at a given rate. The Perpetuity Method uses the Gordon Formula: Terminal Value = FCFn × (1
+ g) ÷ (r – g), where r is the discount rate (discussed in the next section on WACC) and g is
the assumed annual growth rate for the company’s FCF. This will be demonstrated with an
example shortly.
As a sanity check, you can use the terminal method to back into an assumed growth rate for the
business, which should be similar to the growth rate used in the perpetuity method. Examples of
this calculation are discussed later in this section.
USING THE TERMINAL MULTIPLE METHOD
Continuing with our DCF example from earlier, we will demonstrate the two steps needed to apply
the Terminal Multiple Method:
1. Identify reasonable EBITDA multiple range. For this exercise, we are assuming a range of
6.0x-8.0x EV/EBITDA. We chose 6.0x to 8.0x based on historical trading ranges for the
company along with comparable companies in the industry.

2. Multiply the EV/EBITDA multiple range by the end of period EBITDA estimate. The result
equals the Enterprise Value of the company as of the end of the projection period.
Year 6 EBITDA = $13,367
EV/EBITDA Multiple Range = 6.0x – 8.0x

Terminal Value = $13,367 × [6.0x – 8.0x] = $80,203 – $106,938
Here are a couple of important considerations to make when using the Terminal Multiple Method:
Make sure the terminal year is a “normalized” year. Exclude years that are influenced cyclical
factors or economic factors.

The growth rate that the EBITDA multiple implies needs to be in-line with long-term
assumptions.
Be sure to use a “normalized” tax rate in the terminal year. A tax rate can be skewed by
previous losses, one-time items, and a change in international mix.
USING THE PERPETUITY METHOD
The Perpetuity Method uses the assumption that the Free Cash Flows grow at a constant rate in
perpetuity over the given time period. You should use a conservative approach when estimating
growth rates in perpetuity. Analysts typically use long-term growth rates such as GDP growth (or
perhaps something slightly higher), as companies typically can’t register double digit FCF growth
rates forever.
Here are the two steps needed to apply the Perpetuity Method:
1. Identify reasonable long-term FCF growth rates to use in perpetuity, such a GDP or
something slightly higher, depending on industry and company dynamics.

2. Calculate the Terminal Value by taking FCF from the last projection year times (1 + the
perpetual growth rate). Divide this figure by the difference between the discount rate (r) and
the assumed perpetual growth rate (g).
Terminal Value = FCFn × (1 + g) ÷ (r – g)
In this case:
FCFn = last projection period Free Cash Flow (Terminal Free Cash Flow)
g = the perpetual growth rate
r = the discount rate, a.k.a. the Weighted Average Cost of Capital (WACC, covered in the next
section of this training course)
If we assume that WACC = 11% and that the appropriate long-term growth rate is 1%, we get:
This is a very conservative long-term growth rate, and of course higher assumed growth rates will
lead to higher Terminal Value amounts.
RECONCILING THE TWO METHODS
Note that there are formulas to determine the equivalent multiples and growth rates for the two
given methods.
Using the Terminal Multiple Method to solve for the equivalent Perpetuity Method growth
rate:
Using the Perpetuity Method to solve for the equivalent Terminal Multiple Method multiple:
Weighted Average Cost of Capital (WACC): Different ways to

describe the same concept
WACC can be a confusing concept. The technical definition of WACC is the required rate of return
for the entire business given the risks to investors of investing in the business. Meanwhile, the
layperson’s (and probably analyst’s) definition of WACC is the rate used to discount projected Free
Cash Flows (FCF) in a DCF model.
These definitions refer to two sides of the same coin. If an investor requires a specific return on his
investment dollars today, then future cash flows from an investment he makes can be converted into
today’s dollars using that required return to create a “today-equivalent” value for those future cash
flows. (The WACC simply does this for all investors in a company, weighted by their relative size.)
Since the future FCF represent all of the value of a company available to all investors (Debt and
Equity) in the company, they can be discounted by WACC to determine their value in today’s dollars.
But how do we determine what that required return should be? Put simply, it is a function of the
alternative investment opportunities available to all of the investors in the company, and the
riskiness of making that investment in the company relative to those available alternative returns. If
the risk-equivalent return in other opportunities is X% per year, then an investor should require X%
from this investment as well. And in order to gauge the current value of the investment in today’s
dollars, we need to discount all future benefits accruing to those investors (namely, future Cash
flows) by X%.
Here is a summary of things to make sure you understand about the WACC:
When discounting back projected Free Cash Flows and the Terminal Value in the DCF model,
the discount rate used for each Cash flow is WACC.
The capital structure mix of Debt (tax-affected) and Equity times the Cost of Debt and Cost of
Equity equals the WACC. In effect, WACC is the after-tax weighted average of the Costs of
Capital for Debt and Equity, where the weights correspond to the relative amount of each
component that is outstanding.
WACC is a forward-looking rate of return and is directly related to the risk of the investment
and the alternative investment opportunity set available to the company’s investors across the
capital structure (i.e., for the business as a whole, not just for the shareholders).
Now that we have described WACC and what it represents fully, here is the mathematical definition
of WACC:
Where:
KE = Cost of Equity. KE = Krf + b × RP, where Krf equals the Risk Free Rate, b equals the
levered (Equity) Beta for the company, and RP equals the Equity Market Risk Premium. The
Beta and Risk Premium are calculated using the Capital Asset Pricing Model (CAPM).
KD = Cost of Debt. This is the weighted average of interest rates paid on the company’s debt
obligations. Notice that in WACC, Cost of Debt is taken after taxes—i.e., it is multiplied by (1 –
T). This is to acknowledge the fact that Interest Expense on Debt is (generally) tax-deductible,
thereby creating a tax shield which adds value to the company. This is represented in the DCF
framework by reducing the Cost of Debt component of WACC, resulting in a lower discount
rate for the company’s FCF, and therefore a higher valuation for the company.
E = Market Value of Equity, i.e., Market Capitalization.
D = Book Value of the company’s Debt.

T = Marginal Tax Rate for the company. This rate can be different from the Effective Tax Rate
used to determine Tax Expense based on EBIT.
CALCULATING WACC: AN EXAMPLE
Here is an example that illustrates the calculation of WACC for our hypothetical company, using the
average adjusted (levered) beta for a sample of hypothetical, comparable companies:
Other WACC Hints:
WACC takes into account a capital structure that is assumed not to change over time. If it
does, and that change is known, the WACC associated with each future capital structure
should be used instead. An example of this might be a company in a leveraged buyout (LBO)
where the capital structure will be changing as the company reduces Debt.
When using a DCF analysis to value an M&A transaction, use the target company’s WACC
rather than that of the acquiring company. This is because the WACC of the target company
will more accurately reflect the relevant risks inherent in the business being acquired.
←Comparable Company Analysis Precedent Transaction Analysis→
Precedent Transaction Analysis | Street Of Walls 1/9/22, 0:29

In this Precedent Transaction Analysis chapter, we will cover five key topics:
Precedent Transaction Analysis Overview

Peer Universe for Precedent Transactions
Calculating a Precedent Transaction Multiple
Price Premium Analysis Overview

Common Mistakes
Precedent Transaction Analysis Overview
WHAT ARE PRECEDENT TRANSACTIONS?
Precedent Transaction Analysis, also known as “M&A Comps,” “Comparable Transactions,” or “Deal
Comps,” uses previously completed mergers and acquisitions deals involving similar companies to
value a business.
Precedent Transaction Analysis typically uses the same multiples as Comparable Companies’
Analysis (or “Comps”). In particular, Enterprise Value/Sales, Enterprise Value/EBITDA and
Earnings/Earnings Per Share (EPS) are the most commonly used metrics. However, unlike in
Comparable Company Analysis, the basis for value comparison is the price paid by the purchaser
for a business, rather than the traded market values of the company’s securities. These prices can be
different because there is a control premium—the value ascribed to being able to control a
business rather than simply own a percentage of the equity in it. Thus, Precedent Transaction
Analysis will typically result in valuations that are higher than standard Comparable Company
Analysis.
Additionally, Precedent Transaction Analysis tends to focus on the value of a business as of the time
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an acquisition of the business can be completed, rather than today. This is because deals take time
to close, whereas current market values for a business can be assessed on any day. Sometimes, deals
can take as long as a year (or more!) to close, so the Precedent Transaction Analysis should reflect
that fact.
For all of these reasons, Precedent Transaction Analysis should be part of the valuation analysis of
any company in which a change of control (such as via an acquisition) is possible.
Below you will find a detailed overview of Precedent Transactions techniques used by investment
bankers and leveraged buyout investors (also known as “financial sponsors”) to value a company.
WHY USE PRECEDENT TRANSACTIONS?
There are many reasons why a Precedent Transaction Analysis should be used as part of a valuation
exercise:
To value a private business that does not have public trading comparables.
To evaluate the market demand for acquiring a company, based on the total dollar volume
and number of recent transactions in a certain industry.
To provide data analytics in assessing M&A activity and consolidation trends.

To identify potential bidders if the company is looking to be acquired or identify potential
sellers if a company is looking to buy a business.
To provide a fairness opinion to a Board of Directors when a company is acquiring or selling
all or part of a business, or is being acquired.
PRECEDENT TRANSACTIONS ADVANTAGES AND DISADVANTAGES
PROs and CONs of Using Precedent Transactions
PROs CONs
Typically based on publicly Public data is based on past transactions that

available information may not be indicative of current market
Multiples reflect actual payments conditions
for real-life deals, rather than Information available from industry and news
traded multiples that are subject to sources can be misleading

supply and demand pressure Precedent transaction dynamics are rarely
Useful in M&A negotiations and perfectly comparable
discussions Values and multiples obtained may vary over a
Provide guidance to assess what a wide range and the summary metrics may be
buyer may be willing to pay for a of limited usefulness
business Other factors may affect the multiples such as
Can reveal valuable information governance issues, specific agreements,
such as industry consolidation synergies, and intangible values (such as
trends, and potential buyers and patents and other intellectual property)
sellers
Peer Universe for Precedent Transactions
SEARCHING FOR PRECEDENT TRANSACTIONS
Information on Precedent Transactions can typically be found in a number of places:
Previous valuation analyses: A great source for previous transactions is presentation

material that has previously been compiled in a certain industry. This can be a great way to
save time, so be sure to check whether such analyses have recently been conducted at your
bank—chances are high that they have.
Public tender documents and merger proxy statements: Fairness opinions disclosed
in public tender documents and merger proxy statements can provide a wealth of information
about other closed transactions.

SDC database: Securities Data Corporation compiles a database of all completed M&A
transactions and can be used to search for relevant transactions.
Capital IQ or Factset: This database is a widely used internet-access financial database
that has a search feature for M&A transactions that can be filtered by many factors including
target company geography, size, etc.
News internet searches: Try a Google search for industry M&A news.
Equity research: Typically transaction information can be found in initiation reports.
It is important to note that primary sources are always the best source of information regarding
M&A multiples. We suggest using information that is disclosed directly by a company, such as a
merger proxy statement. Documents available via the SEC should be close in quality to primary
documents, because the SEC is where public companies disclose press releases and all major
corporate and financial events. Also valuable are Equity Research reports, if they are cross-verified
by company press releases and proxy statements. By contrast, multiples available from databases
such as SDC, Capital IQ and Factset may need to be verified.
SELECTING THE APPROPRIATE PRECEDENT TRANSACTIONS
The appropriate selection of a relevant peer universe is critical for a Precedent Transaction Analysis,
because it plays a significant role in the valuation of the company, when viewed as a potential M&A
target. For example, a company could sometimes be compared across two different industries due to
the nature of the business (e.g. an internet retail company). This will affect which comparable
transactions to use. Similarly, some comparable transactions might need to be ruled out or adjusted
because of specific transaction dynamics. Finding the right Precedent Transaction Peer Universe can
therefore be somewhat subjective.
The best Precedent Transactions to use are those in which the target companies and the company
you are valuing have the most similar business and financial characteristics. These characteristics
include the following:
Same business & industry

Similar business size
Similar sales growth rates and profitability margins
Similar capital structure
Similar reasons for transaction (e.g. fire sale, bankruptcy, or strategic motive).
Same geographic location of operations
The best way to get a relevant set of Precedent M&A transactions is to go to one relevant example
transaction and search for the Fairness Opinion filed in a target company’s Merger Proxy (filed with
the SEC under Form S-4). That Fairness Opinion should include a robust set of relevant transactions
that are similar to the one disclosed in the S-4 document.
For example, let’s assume that we are looking for comparables to a company that conducts its
business in the cloud-computing sector. In 2011, Time Warner Cable acquired NaviSite, a cloud-
computing business, for approximately $230 million. The relevant transaction filing can be found on
the SEC website.
In this document, we can search for the fairness opinion conducted by Raymond James & Associate
using the search text “Selected Transaction Analysis.” Raymond James states the following:
“While none of the companies (other than the Company) that participated in the
selected transactions are directly comparable to the Company, the companies that
participated in the selected transactions are companies with operations that, for the
purposes of this analysis, may be considered similar to certain operations of the
Company. Raymond James excluded transactions whose targets may have offered
services similar to those of the Company, but that also derived a large part of their
revenues from businesses dissimilar to those of the Company.”
Just prior to this quote, the Raymond James analysis provides a relevant set of 15 comparable
transactions to help get us started.
Based on the set of transactions listed in the proxy statement, Raymond James concluded that the
Precedent Transactions multiples were as follows:
From the analysis summary, Raymond James demonstrates that the merger consideration for the
NaviSite acquisition is relatively close to the average multiples of the selected transactions, if
measured in terms of Enterprise Value/EBITDA. In terms of Enterprise Value/Revenue, the
consideration is on the low side—but the implication is that NaviSite has a low EBITDA margin
relative to the universe of companies used in this analysis.
CALCULATING A PRECEDENT TRANSACTION MULTIPLE
Let’s take a look at a completed precedent transaction and determine the relevant multiples for that
transaction. The key information to be gathered includes the following:
Announcement date
Target and acquirer name
Consideration type (cash or stock)
Equity Value (based on offer share price and diluted shares outstanding)
Enterprise Value (based on equity value plus net debt)
LTM financial results of the target
The example we will use is the acquisition of J.Crew Group for $43.50 per share in cash by TPG
Capital and Leonard Green & Partners. The press release states, “The price represents a premium of
29% to J.Crew’s average closing share price over the last month.” From the press release and
supporting SEC filings, we can gather and compute the key information described above.
The first step is to calculate the market value of J.Crew prior to the announcement. There were
63.741 million basic shares outstanding prior to the announcement, according to SEC filings. This
document shows that the company had approximately 7.977 million options outstanding. Therefore,
we can assume the diluted share count equals 63.741 + 7.977 = 71.718 million. For the equity value of
J.Crew, we use the offer price times the dilutive shares outstanding. Therefore, J.Crew’s implied
Equity Value is [71.718 million × $43.50] = $3,120 million.
Next, we calculate the implied enterprise value, or total consideration, by taking the equity value and
adding total debt balance minus total cash and short- term investments. According to the 10-Q
filing, J.Crew had $340.5 million in cash and $49.2 million in total debt as of July 31, 2010. Thus,
J.Crew’s implied Enterprise Value is therefore [$3,120 + $49.2 – $340.5] million = $2,828 million.
Finally, we can gather the Last Twelve Months (LTM) financial data from J.Crew’s SEC filings. A
review of these documents shows that J.Crew’s LTM revenue was $1.711 billion and its LTM EBITDA
was $320.78 million. From this data, we can calculate the following multiples for this Precedent
Transaction:
In addition to the historical acquisition multiples, investment bankers use research reports that
were published prior to the announcement of the deal (this is very important) to get a sense of
projected financial performance estimates. From these, we can compute what forward/estimated
acquisition multiples were used. For example, if J.Crew was expected to have revenue of $2.5 billion
in 2011, then we can assume that the 2011E EV/Revenue multiple for the transaction was 1.1x.
This procedure can be repeated for each relevation transaction in the Peer Universe. Once this is
completed, aggregate statistics for the multiples should be presented (minimum, median, mean and
maximum).
An example analysis would look something like this:
Additional points to note as you are performing a Precedent Transaction Analysis include the
following:
Enterprise Value = Equity Value + Total Debt – Cash + Minority Interest + Preferred Equity.
Calculate LTM financial performance based on latest filings prior to announcement.
Determine projected financial performance by using a recent research report published prior
to announcement.
Exclude extraordinary one-time items such as restructuring charges. Make sure to footnote
any such exclusions.
Look for convertible securities that may convert upon change of control of the target. These
securities will likely be included in the diluted share count.
Always double-check your work! Cross check research reports, company filings and press
releases.
Price Premium Analysis Overview
Investment bankers calculate the control premium of Precedent M&A Transactions to

approximate the appropriate offer price premium for a target company. Typically, the difference
between the share price one day prior to announcement and the offer price is used. The following is
an example of a Precedent Transaction Analysis that included Price Premium data:
The formula for Premium Paid (as a percentage above market) is:
Premium Paid (%) = (Acquisition Price ÷ Last Trading Price – 1) × 100
Where “Last Trading Price” is generally the closing price of the stock the day before the acquisition
announcement is made.
For example, if Company A last traded at $100 per share upon Wednesday’s close, and Company B
announces its intent to acquire Company A for $125 per share on Wednesday evening, Company B is
paying a 25% premium over the market price to gain control of Company A.
In some cases, there are rumors or leaked information regarding potential M&A activity that can
manipulate or impact the trading price of a potential target company’s stock price. Therefore,
investment bankers can also perform a price premium analysis relative to the price one week or one
month prior to announcement.
Pitfalls To Avoid When Using Precedent Transactions
There are a number of common ways that mistakes can be made when performing Precedent
Transaction Analysis. Be sure to review this checklist of pitfalls to avoid before completing the
analysis:
INCONSISTENT ANNOUNCEMENT DATE OR EFFECTIVE TRANSACTION DATE
Always keep your data points consistent. If you are looking at a set of precedent transactions, be sure
to use the LTM data points when calculating the respective multiples (rather than, for example,
using multiples based upon the prior fiscal year end). Keeping the data points consistent in your
analysis will ensure a more consistent valuation. If any data points are not consistent and difficult to
make consistent, make sure to footnote them, and at least consider removing them from the
aggregate statistics for the analysis.
INCLUDING EXTRAORDINARY ITEMS
Make sure to exclude any one-time items from the financial results data. These items may include
gains/losses on sales of assets, legal expenses, write-offs or restructuring expenses. Always footnote
any exclusion.
INCLUDING MINORITY INTERESTS IN FINANCIAL RESULTS
Any minority interest expense or income should be excluded from the financial data points used to
calculate multiples if the minority interest is not related to the company’s core line of business.
Always footnote any exclusion.
TAKING THE NUMBERS STRAIGHT FROM AN ONLINE FINANCIAL DATABASE
It is imperative that you conduct your own research on any given transaction. Financial databases
often have inaccurate or imprecise metrics. Try to always use primary sources when possible, as this
should help ensure that the data is accurate and appropriately adjusted for extraordinary items.
FAILING TO CALCULATE THE PREMIUM OVER MARKET VALUE
Be sure to calculate the true premium of an offer price – in other words, make sure that the market
price prior to the transaction has not been manipulated by market rumors or insider trading.
Charting the stock price over the previous six month prior to announcement of the transaction can
give you a sense of what the historical price was prior to any possible appreciation immediately prior
to announcement caused by information leaks or illicit behavior.
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31/8/22, 23:16 Valuation: A Conceptual Overview | Street Of Walls

STREETOFWALLS ARTICLES TRAINING

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VALUATION: A CONCEPTUAL OVERVIEW

Enterprise Value: The 30,000-Foot View

Understanding Enterprise Value vs. Market Value

Enterprise Value: The 30,000-Foot View

introduced in the next chapter, Valuation Techniques Overview.

techniques used by investment bankers.

Operating Value) of a Company.

Let’s start with a basic identity equation:

Operating Value of a Company =

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

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

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

Visually, we can look at this two different ways:

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

2. ENTERPRISE VALUE = NET VALUE OF ALL CLAIMS

ANOTHER VIEW OF ENTERPRISE VALUE

Real Estate, Commodities, Stock Options, etc.

impacting the Company’s cash-generating operations.)

PRIMARY COMPONENTS OF NET DEBT

problem (or crisis).

Understanding Enterprise Value vs. Market Value

which do we use, and when? In a nutshell:

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

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

Earnings Per Share, or EPS)

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

companies utilize different amounts of leverage.

This concept is demonstrated in the following graphic:

An Introduction to Valuation Techniques

COMPARABLE COMPANY ANALYSIS

THE THREE MAIN STEPS OF A COMPS VALUATION

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

COMPARABLE COMPANIES ANALYSIS EXAMPLE

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

DISCOUNTED CASH FLOW (DCF) ANALYSIS

THE FOUR MAIN STEPS OF A DCF VALUATION

2. Calculate the Weighted Average Cost of Capital (WACC).

PRECEDENT TRANSACTION ANALYSIS

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

THE THREE MAIN STEPS OF PRECEDENT VALUATION

1. Identify publicly traded companies with similar characteristics.

PRECEDENT TRANSACTION ANALYSIS EXAMPLE

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

LEVERAGED BUYOUT (LBO) ANALYSIS

great depth in the Private Equity Training Module.

business within 5 years after purchase.

THE FIVE MAIN STEPS IN AN LBO ANALYSIS

down each year.

←Introduction Valuation Techniques Overview→

STREETOFWALLS ARTICLES TRAINING

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VALUATION TECHNIQUES OVERVIEW

(usually advisory services for corporate actions like M&A).

In this chapter we will cover two primary topic areas:

techniques are typically used?

Valuation Techniques: Overview

Comparable Company Analysis (Public Comps): Evaluating other, similar companies’

Leverage Buyout/“Ability to Pay” Analysis (LBO): Valuing a company by assuming the

considered proficient at his or her job.

When To Use Each Valuation Technique