Valuation

Enterprise value

What’s Enterprise Value and what does it mean?

Market Cap (or Equity Value) + Debt – Cash (more advanced: Market Cap + Debt + Preferred Stock + Minority Interest – Cash). It is a valuation that is available to both bond and equity holders as it includes Net Debt and can be derived by using Sales or EBITDA multiples

Why do we add Debt and subtract Cash?

When you purchase a company, you are also liable for its debt and own its cash balance. So you adjust for its liabilities (money borrowed from future incomes) and cash at hand (money already earned from the past). The “Equity Value” is also the purchase price you have to pay

What valuation methods do you know? What are the most common valuation methods you know?

Comparable company analysis – using trading multiples of similar companies to justify a valuation multiple
Comparable transaction analysis – using valuation multiples of similar transactions to justify a valuation multiple
DCF – using future free cash flows to value a company
LBO – you are purchasing a company with debt to flip it and making your money back. So it’s entry price vs exit price while considering potential cost & revenue synergies during the holding period to justify the entry valuation

Which valuation methods yields the highest valuation?

It depends. But generally, Comparable Transactions > Comparable Companies. Comparable Transactions include the premium paid in a competitive bidding process. A DCF could yield higher valuations depending on the underlying business plan. An LBO usually yields a lower valuation as it is a leveraged buyout driven by IRR rather than a strategic transaction

Who would pay more for a deal? A strategic investor or private equity investor

In general, a strategic investor would likely pay more because they can realize more synergies. They operate in the same space and can expand products quicker or access each others' clients. A financial investor can only grow the company, make it leaner and then flip it

Why would a company rather use stocks vs cash to fund the transaction?

The company uses stocks if (1) the company wants to take advantage of its high stock price or (2) does not have enough cash and is unwilling to take out debt to finance the transaction

What are synergies in a transaction?

There are two types of synergies: (1) Revenues synergies include access to each others’ clients (e.g. different geographies or different target groups) or combining product portfolios. (2) Cost synergies include the reduction of overhead functions, such as combining facilities, reducing admin headcounts or gaining more bargaining power with suppliers

What does it mean if a transaction is accretive?

A transaction is considered accretive if the combined new company has a higher Net Income post merger. The negative impact from the acquisition (interest lost on cash, financing costs, post-merger integration) should be offset by additional Net Income. A transaction is considered dilutive if the acquisition causes Net Income to drop post merger. Rule of thumb for stock transactions: If a P/E ratio is higher, the transaction is likely to be dilutive as you are paying more per earnings. If you add a company with a lower P/E ratio, you are adding a company with lower “costs per earning” and likely to be accretive

What are the most common multiples do you know?

EV/Sales. Very crude as it only accounts for revenues. Mostly used for EBITDA and cashflow negative companies
EV/EBITDA. The most used multiple. It is the quickest proxy for cash flow, however it ignores capex and D&A
EV/EBIT. Better for capex intensive sectors as it accounts for D&A
P/E ratio. Most used equity multiple. “Price per earning” multiple
Price/Book Value. Most widely used in valuing financial institutions because their assets (e.g. loans and deposits) drive their earnings

Estimate the Enterprise Value of a company. You have 3x LTM Sales and 10x LTM EBITDA and an LTM Income Statement

What are the advantages and disadvantages of using multiples from comparable companies?

Trading comps offer a quick way to estimate the valuation of a company (no business plan required). However, no two companies are exactly identical. The rationale of your peer group will be under great scrutiny. Every. Single. Time. Companies, even in the same sector, may have different growth rates and varying margins. This creates a problem justifying an exact multiple to be applied to your target company

Walk me through a DCF

First, we would project the companies P&L for 5 years and would then derive the Unlevered Free Cash Flow, the cash flow available for both equity and debt investors. EBITDA – Taxes +/ – Changes in Working Capital – Capex. DCF = CF1/(1+r)+(CF2/(1+r)^2…..+(CF5/(1+r)^5+FCFN(1+g)/(R – g) (discount back to 5). CF = Cash flow, R = Discount Rate, G = Long-Term Growth. Alternatively, use an exit multiple to EBITDA for the terminal value and discount back

What are the flaws of a DCF?

A DCF is best suited to value stable, predictable and cashflow positive companies. Companies with negative cash flows or exponential growth in the future can make the valuation more terminal value heavy (<70%). The quality of a DCF analysis depends on the underlying business plan for the next 5 years. Too aggressive assumptions will lead to an inflated valuation

How do you calculate the discount rate?

WACC = ((Cost of Debt*(Debt/(Debt + Equity))*(1 – Tax Rate))+(Cost of Equity*(Equity/(Debt + Equity))
Cost of Equity = Risk-Free Rate + ((Beta * (Market Return – Risk Free Return))
Un-Levered Beta = Levered Beta / (1+((1-Tax Rate)*(Total Debt/Equity)))
Levered Beta = Un-Levered Beta * (1+((1-Tax Rate)*(Total Debt/Equity)))
Cost of Debt = The interest rate at which the company borrows money