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Valuation
Process of determining the "right" value of a business, several approaches used, influenced by objectives of those doing the valuation
How do you value a company?
There are a number of ways, mainly fall under two categories:
- Intrinsic Valuation - based on ability of company to generate cash flows. DCF is most common type of intrinsic valuation - looks at company's cash flow forecasts and risks.
- Discounted Cash flow: value a company by looking at the future cash flows it can generate and discount them to the present to arrive at a present value of your business
- Relative Valuation - looks at multiples of comparable companies and applies mean/median multiple from peer group. Can be multiples of current market values (trading comps) or historical acquisition multiples (deal comps)
- Comparable company analysis: value a company by finding similar companies that are public and have readily observable market prices.
- Comparable (precedent) transactions analysis: value a company by looking at the amount buyers have paid for acquiring similar companies in the recent past
How do you value a company when not using DCF or relative valuation?
- Leveraged Buyout Analysis: a specific type of valuation approach that looks at the value of a company to new acquirers under a highly leveraged scenario with specific return requirements. Hybrid of DCF and comps valuation.
- Liquidation (Bankruptcy) Analysis: value a company under a worst case liquidation scenario.
What's the difference between equity and enterprise value?
Equity Value: the value of a business to its owners.
=(Operating Assets - Operating Liabilities) + (Cash - Debt)
- Cash: includes cash as well as nonoperating assets like marketable securities, short term investments, equity investments
- Debt: includes straight debt (loans, revolver, bonds) as well as debt-like investments like capital leases, non-controlling interests, preferred stock
=Enterprise value - net debt
Enterprise value: value of a company's operations, not its equity
=Operating Assets - Operating Liabilities
- Operating Assets: all assets except for cash and other investment assets
- Operating Liabilities: all liabilities except for debt and debt like liabilities
What's the difference between book and market value?
Book value: a company's value as a function of what the balance sheet tells us.
Market value: usually higher than book value since it is a function of future expectations, not historical carrying values
Steps 1&2 to Building a DCF
- Forecasting Unlevered Free Cash Flows (UFCFs): Step 1 is to forecast the cash flows a company generates from its core operations after accounting for all operating expenses and investments. These cash flows are called "unlevered free cash flows." This forecasting should be done for 5 to 10 years max. UFCF formula: EBIT*(1-tax rate) + D&A - capex - networking capital
Networking capital = non-cash working capital = current assets - cash - current liabilities
- Calculating Terminal Value: You can't keep forecasting cash flows forever. At some point, you must make some high level assumptions about cash flows beyond the final explicit forecast year by estimating a lump-sum value of the business past its explicit forecast period. That lump sum is called the "terminal value." Can be calculated with perpetuity growth method or the exit multiple method.
Perpetuity Growth Method and Exit Multiple Method
Perpetuity Growth: TV = (FCFn * (1+g)) / (WACC - g)
FCFn = FCF final forecast year
G = growth rate ... can be GDP of the country or industry growth rate
Exit Multiple: TV = financial metric * trading multiple
Financial Metric Example = EBITDA
Trading Multiple Example = Enterprise Value / EBITDA
Step 3 to Building a DCF
- Discounting the cash flows and terminal value to the present at the weighted average cost of capital: The discount rate that reflects the riskiness of the UFCFs is called the weighted average cost of capital (WACC). Because unlevered free cash flows represent all operating cash flows, these cash flows "belong" to both the company's lenders and owners. As such, the risks of both providers of capital need to be
accounted for using appropriate capital structure weights (hence the term "weighted average" cost of capital). Once discounted, the present value of all UFCFs is the enterprise value. Also, when discounting the terminal value, use the discount rate of the final year projected.
WACC Formula; Capital Asset Pricing Model (CAPM); Cost of Equity Formula
WACC: rate of return required by debt and equity investors for your company to fund the growth of its future FCF... discount rate used to determine present value of your FCF
WACC Formula = (E/(E+D))Re + (D/(E+D))Rd(1-t) ... Proportion of Equity cost of equity + Proportion of Debt * cost of debt
Re calculated with Capital Asset Pricing Model... Re = E(Ri) = Rf + Bi(E(Rm))-Rf) ...
E(Ri) = expected return
Rf = risk free rate (typically 10 year US treasury)
Bi = beta = stocks volatility in relation to the market (like the S&P500) where the market has a beta of 1... if your company has beta of 2, when market goes up 10% your company goes up by 20% ... measures a company's sensitivity to systematic (market) risk
E(Rm) = expected market return
Step 4 to Building a DCF
- Add the value of non-operating assets to the present value of UFCFs: The ultimate goal of the DCF is to get at what belongs to the equity owners (equity value). Therefore, if a company has any non-operating assets such as cash or has some investments just sitting on the balance sheet, we must add them to the present value of UFCFs. For example, if we calculate that the present value of Apple's unlevered free cash flows is about $700 billion, but then we discover that Apple also has $250 billion in cash just sitting around, we should add this cash.
Steps 5&6 to building a DCF
Assumption Weaknesses:
Operating assumptions (revenue growth and operating margins)
WACC particularly cost of equity
Terminal value: long term growth rate or exit multiple
Strengths and Weaknesses of Relative Valuation
Strengths: requires no specific assumptions about a company's future prospects, and is based on "reality" - observable prices for similar companies in the market
Weaknesses: Different Multiples show different values... if incentivized to find higher value, you'll select multiples that accomplish that
Advantages & Disadvantages to Trading Comps
Advantages: reality based valuation... provides a framework to value a company based on current market conditions, industry trends and growth of companies with similar operating and financial statistics. A sanity shock to DCF... DCF is highly sensitive to explicit assumptions about a company's future performance, making it easy to have it say whatever you want. Comps relies on observable market prices as keyy input, making it a sanity check
Disadvantages: truly comparable companies are rare and differences are hard to account for. Explaining value gaps b/t company and comparables involves judgement. Does not reflect intrinsic value since stock market is emotional and fluctuates irrationally. Less useful for public companies bc you'd be arguing that the market is wrong about pricing this company, but in general is right. Liquidity: thinly traded, small cap, or poorly followed stocks may not reflect fundamental value because of price swings due to liquidity issues
When would a DCF be an inappropriate valuation method?
What's the difference between levered and unlevered FCF?
Which is typically higher - the cost of debt or the cost of equity?
The cost of equity is higher than the cost of debt because the cost associated with borrowing debt (interest expense) is tax deductible, creating a tax shield. Additionally, the cost of equity is typically higher because unlike lenders, equity investors are not guaranteed fixed payments, and are last in line at liquidation.
Which multiples are the most popular in valuation?
Enterprise Value (EV) Multiples:
- EV/EBITDA
- EV/Revenue
- EV/EBIT
- EV/Industry Specific Metric
Equity Value Multiples
- P/E Ratio (share price / EPS)
- Market Cap / Net Income
=P/E to Growth (PEG Ratio)
How do you value Bitcoin?
What is investment banking?
The investment bank performs two basic, critical functions: acting as an intermediary for capital raising, and as an advisor on M&A transactions and other major corporate actions. As an intermediary, it connects companies that need capital with investors who have capital to spend. It facilitates this through debt and equity offerings. As an advisor, an investment bank counsels companies on such corporate actions as mergers, acquisitions, spinoffs, and restructurings.
has 3 main types of activities:
- Helping corporate customers obtain funding by selling securities such as stocks and bonds to investors
- Providing advice to corporate clients on strategic transactions such as mergers and acquisitions
- Trading debt and equity securities for customers or for the firm's own account
Walk me through how $10 of depreciation affects the statements...
Income Statement: decreases operating income by $10, assuming a 40% tax rates, decreases net income by $
Cash Flow: from there, the $6 less of net income flows into the top line of the cash flow statement, but since depreciation is a non-cash expense, it could be added back in below net income, resulting in a $ net change in cash
Balance Sheet: this $4 increase in cash would flow into the balance sheet, and the actual $10 of depreciation would decrease the value of PP&E, meaning there is a $6 reduction in assets. The $ decreases in net income mentioned before would impact the SE section of the balance sheet, making the L+SE side balance with assets.
Walk me through the three statements...
How do the three statements link together?
