Valuation

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Table of Contents
I. Valuation Overview II. Comparable Public Companies III. Precedent Transactions V. Discounted Cash Flow (DCF) Analysis VI. Conclusions

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What Is Valuation?
How much is Computer Retailer Company A worth? (i.e. what is its valuation?) Company A will have different values to different buyers Would the following buyers be willing to pay more or less for a piece of the Companys equity?
An individual or fund looking to buy stock in the public market and be a minority shareholder (i.e. does not have much influence on the companys management, operations, strategy, etc., other than the occasional shareholder vote) A competitor looking to acquire 100% of the company and merge it into its own company, with the intention of attaining synergies such as price increases to customers, operational efficiencies, savings from shutting down one corporate headquarters and firing redundant employees, etc. A private equity firm that wants to buy 100% of the company for its own investment portfolio, and therefore have strong influence and control over the companys management team, strategy, operations, etc.

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What Is Valuation? (cont.)

If Company A is listed on a stock exchange and its equity shares are publicly traded, then you can derive its valuation (i.e. how much it is worth) based upon the share price and other publicly available information such as SEC filings, research reports and press releases
This is the Public Market Valuation

The Public Market Valuation provides one perspective on the Companys valuation: it illustrates at what price minority shareholders are willing to buy and sell the equity shares of that company In addition to the Public Market Valuation, there are three methodologies commonly used to derive a companys valuation, providing three different valuation perspectives:
(1) Comparable Public Companies (aka Trading Multiples) (2) Precedent Transactions (aka Acquisition Multiples) (3) Discounted Cash Flows (DCF)

These three methodologies allow for the valuation of both publicly traded companies and privately held companies, provided you have some or all of the following information for the company that you want to value:
Recent income statement information (Revenues, EBIT, EBITDA, Net Income, etc.) for the company that you want to value Recent balance sheet information (cash balance, debt balance, minority interest balance, preferred and common equity information, number of equity shares outstanding, etc.) Projected income statement information (for next 1 2 years)

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What Is Valuation? (cont.)

Every transaction requires an understanding and agreement of a companys fair market value (FMV)
What is FMV?
Price at which an interested, but not desperate, buyer is willing to pay and an interested, but not desperate, seller is willing to accept on the open market How is this different from book value?

What is market value of equity (MVE)?

MVE or market cap = price per share x total shares outstanding MVE vs. stockholders equity on the balance sheet

MVE

aggregate value

MVE represents only the value from stockholders What about the value contributed by other stakeholders? Aggregate or total enterprise value (TEV) is the value attributed to ALL providers of capital

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Total Enterprise Value (TEV)

Company valuations are performed for the purpose of determining the value of the operations
Does not focus on value to specific stakeholders (e.g. MVE) Ignores leverage Think of real estate to differentiate between TEV and MVE:
House value = TEV; home equity = MVE; mortgage = debt

TEV = MVE + debt + preferred stock + minority interest cash

Share Price = $50.00 Shares Outstanding = 200 million Preferred Stock = $0 Debt = $2,000 million Minority Interest = $0 Cash = $500 million TEV = ?

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Total Enterprise Value (TEV) (cont.)

Remember, common stock, preferred stock, debt and minority interest are ALL providers of capital (right-side of the balance sheet) What is minority interest and why is it included in TEV?
If you own more than 50% but less than 100% of another entity, you are required to consolidate its financials on to your company financials. Minority interest represents the portion of equity that your company does not own it is a liability Therefore, in a TEV / Revenue calculation, if your denominator represents a fully consolidated operating figure, it is necessary to gross up your numerator (TEV) to keep the equation balanced or apples to apples In a leveraged multiple such as P/E, this adjustment is not a concern because the earnings calculation is net of minority interest (i.e. minority interest expense has already been taken out)
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Total Enterprise Value (TEV) (cont.)

Why do we subtract cash in the TEV calculation?
Common misconception: cash is netted against debt Cash sitting on the books is not a contribution of value to the enterprise or operations
However, cash is a contribution to MVE (i.e. value to stockholders) Therefore, because cash is in MVE, which is a component of TEV, we need to subtract cash

To further understand the exclusion of cash, think of two (2) runners of equal ability
Runner 1 has $5.00 in his pocket Runner 2 has $100.00 in his pocket Is Runner 2 necessarily a better or more valuable runner than Runner 1?

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Table of Contents
I. Valuation Overview II. Comparable Public Companies III. Precedent Transactions V. Discounted Cash Flow (DCF) Analysis VI. Conclusions

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Comparable Public Companies

You can value a company based on how similar companies trade in the public markets The first step is to pick the comp universe (size depends on relevance)
The goal is to find companies of similar:

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Industries Business Models Profitability Size Growth Geography (International vs. Domestic) Equity research reports Competitors section from 10-K SIC codes Internet Senior bankers
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Sources include:

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Multiples Analysis
Relative valuation is a method based on applying multiples
A valuation multiple is a ratio between a value and an operating metric (financial institutions may look at balance sheet metrics)
For example: P/E ratio; price = value, earnings = operating metric Therefore, with a given multiple and a variable, you can determine the missing variable P/E = 25.5x, Earnings = $30 million; MVE = ?

There are two (2) types of trading multiples

Operating (debt-free) Equity

Operating (debt-free) multiples

TEV / Revenue, EBIT or EBITDA TEV = $11,500M; Revenue = $19,426M; EBITDA = $1,369M Revenue Multiple = 0.59x EBITDA Multiple = 8.4x
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Operating Multiples
Why is TEV a part of operating multiples and not MVE?
Apples to Apples Remember, TEV ignores specific capital contribution Line items before interest are considered debt-free MVE is value to only stockholders and is affected by leverage

Lets say our subject company, a widget maker, has annual financials of the following:
Revenue: $19,426 million EBITDA: $1,369 million

Mean trading multiples for publicly-traded widget companies

TEV / Rev: 0.74x TEV / EBITDA: 10.3x

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Operating Multiples (cont.)

Whats is our companys implied TEV?
Revenue: $19,426 million EBITDA: $1,369 million Implied TEV using revenue multiple = $19,426 million * 0.74x = $14,375 million Implied TEV using EBITDA multiple = $1,369 million * 0.74x = $14,101 million Average Implied TEV = average ($14,375 million, $14,101 million) = $14,238

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Equity Multiples
Unlike operating multiples, equity multiples are a function of MVE Since the general public owns common stock and not other types of securities, analysts speak in P/E ratios
Price per Share / Earnings per Share Market Cap / Earnings

Again P/E is a function of MVE, which is not a good indicator of company valuation Equity multiples require the denominator to be below the interest line (i.e. net income)
Again, Apples to Apples Wrong: TEV / Earnings Wrong: Market Cap / EBITDA

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Spreading Comps
Spreading comparable public companies and precedent transactions require an apples to apples comparison
Same time frame Last Twelve Months (LTM), Fiscal Year End (FYE) or latest quarter annualized (LQA)
Always use most recent financials Companies have different fiscal year-ends

Normalizing numbers adjusting EBIT, EBITDA and net income

Normal operating status Back-out non-recurring items (operating vs. non-operating) Include certain recurring items (operating vs. non-operating) Continued vs. discontinued operations

Forward-looking numbers are very important

Many growth industries (e.g. technology) only look at FYE+1 or +2 Historical performance is not an indicator of future performance Projections are sourced from management and equity/high yield/credit research reports

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Spreading Comps (cont.)

Calculating TEV
All components need to be at fair market value
MVE = current share price x fully diluted shares outstanding* FMV of preferred stock = public market price or liquidation preference (notes) FMV of debt = generally face value unless distressed (balance sheet) FMV of minority interest = what is stated on balance sheet FMV of cash = what is stated on balance sheet
*discussed on following pages

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Spreading Comps (cont.)

Calculating Fully-Diluted Shares
Basic vs. fully-diluted (FD) shares outstanding
Dilution is built into the stock price
if dilutive securities are in-the-money, the market assumes that the securities are already converted to common stock A convertible security or option is in-the-money if the current share price is greater than the strike price

Dilutive securities include:

Options Warrants Convertible preferred stock or debt (do not double-count if already converted)

Market Capitalization and TEV should always be calculated using fully-diluted shares
Using basic shares outstanding will undercut the valuation, sometimes significantly In certain industries where options are a large part of employee compensation and incentive, the amount of dilutive shares can be sizeable
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Spreading Comps (cont.)

There are two (2) generally accepted methods for calculating dilutive shares
1. 2.

Weighted-average dilutive shares assumed by management The Treasury Stock Method (TSM) Looks at the weighted-average number of new shares created from unexercised in-the-money warrants and options over a period of time
Commonly used in the calculation of diluted EPS Applies greater weight to those periods of higher earnings Does not provide an accurate spot account of the total number of inthe-money securities Most recent account of dilutive data (available in the 10Q and 10K) Lack of transparency or support - based on management discretion Ignores the effect of proceeds received from exercising dilutive securities
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1. Weighted-average dilutive shares

Located in the EPS note of the notes section

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Spreading Comps (cont.)

2. The Treasury Stock Method (TSM)
The net of new shares potentially created by unexercised in-themoney warrants and options This method assumes that the proceeds that a company receives from an in-the-money option exercise are used to repurchase common shares in the market TSM = Exercisable Options Outstanding x (Share Price - Strike Price) / Share Price
Exercisable Options Outstanding is only found in the Options Table in the notes section of the 10K
Full-year lag between a new set of updated options information

Exercisable Options Outstanding represents the portion of Total Options Outstanding which is vested or earned
Note: Total Options Outstanding is used in the TSM for Precedent Transactions due to change of control provisions (to be explained in the next section)

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Spreading Comps (cont.)

2. The Treasury Stock Method (TSM) (cont.)
TSM does not account for in-the-money convertible preferred or convertible debt
This must be calculated separately by figuring out the conversion prices or conversion ratios of each of the convertible securities
Conversion prices or conversion ratios are always detailed in the bond indenture or birth document of a convertible security and oftentimes in a 10K

If convertible securities are in-the-money, they are converted in equity as a form of dilutive securities In the calculation of TEV, be careful not to double count preconverted and post-converted values of the same security
The conversion of a convertible security into equity means that its preconverted form can no longer exist For example, if you convert $500 million of convertible debt into dilutive shares, you must remember to remove $500 million from total debt

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Spreading Comps (cont.)

Best Buy Co. Comp Spread Example

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Selecting Multiples and Ranges

Selecting multiples for implied valuation
Eliminate outliers Average (mean) vs. median Total versus stripped averages Upper and lower quartiles

Risk Rankings
Emphasis towards companies with closer business models, size, growth and profitability, etc.

Identifying meaningful implied valuation ranges

Not too narrow, not too broad Be consistent

Public vs. private value

Liquidity discount Research coverage
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Table of Contents
I. Valuation Overview II. Comparable Public Companies III. Precedent Transactions V. Discounted Cash Flow (DCF) Analysis VI. Conclusions

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Precedent Transactions
Another form of relative value is precedent transactions
Many argue the most accurate way of determining valuation is observing what has been recently paid for comparable businesses in the same space
Rather than looking to the public markets for comparable company valuations, you look at valuations based on acquisitions

Again, this is a multiples-based valuation (operating and equity multiples)

Multiples which are derived from these transactions are applied to a companys operating statistics to determine valuation

Precedent transactions yield an acquisition or control premium (approx: 20-25% depending on the industry)
Remember to adjust for minority interest-based valuations

Selecting comparable transactions

Target company characteristics Transaction parameters Time frame
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Precedent Transactions (cont.)

Data sources:
SDC or other M&A databases SEC filings Equity research reports Press releases (company or third-party) Industry news

Typical information
Announce date vs. transaction date
The price at which a transaction closes at can sometimes be materially different from the original price offered at announce date The spread can be associated to:
Change in target or acquirer stock price Transaction-related adjustments

Considerations should be independent of unforeseen price fluctuations and transaction-specific costs

Target and acquirer descriptions

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Precedent Transactions (cont.)

Typical information (cont.)
Transaction rationale
What are the business decisions for this acquisition
Product expansion, cost synergies, technology integration, etc.

What are the financial decisions for this acquisition

Under-valued stock, poor capitalization, turn-around candidate, etc.

What is the consideration and structure

100% cash 100% acquirers stock
Exchange Ratio: The number of shares of the acquiring company that a shareholder will receive for one share of the target company.

Combination of cash and stock

Each share of target company will receive $12.65 in cash and 1.45 shares of acquiring company What is the consideration if there are 24 million target shares outstanding and the acquiring companys stock price is worth $6.55 at announce date?

Earn-out provisions
Portion of the consideration withheld until operational milestones are achieved
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Precedent Transactions (cont.)

Typical information (cont.)
Implied TEV and MVE Selected financial and operating information Implied valuation multiples Market premiums
Purchase price divided by the (i) 1-day, (ii) 5-day and (iii) 30-day average stock price prior to announce date

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Table of Contents
I. Valuation Overview II. Comparable Public Companies III. Precedent Transactions V. Discounted Cash Flow (DCF) Analysis VI. Conclusions

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Discounted Cash Flow Overview

The DCF calculation represents a companys intrinsic value
Takes all cash flows projected into the future (infinitely) and discounts it back to present value
Forecasting Free Cash Flows Identify components of FCF Keep in mind historical figures Project financials using assumptions Decide # of years to forecast Estimate Cost of Capital Perform a WACC analysis Develop target capital structure Estimate cost of equity Estimating Terminal Value Determine whether to use cash flow multiple (i.e., EBITDA multiple) or growth rate method (i.e., Gordon Growth Method) Discount it back to present value Calculating Results Bring all cash flows to present value Perform sensitivity analysis Interpret results

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Pros and Cons of Discounted Cash Flow

DCF is more flexible than other valuation methodologies. However, it is very sensitive to the estimated cash flows, discount rate and terminal value
PROS Objective framework for assessing cash flows and risk Not dependent upon publicly available information CONS Very sensitive to cash flows Unbalanced valuation weight to terminal value Cost of capital depends on beta and market risk premium

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Discounted Cash Flow (DCF) Analysis

Free cash flow (FCF) represents cash flow to ALL stakeholders, hence it is a depiction of TEV
Unlevered value of the firm that is independent of its capital structure or also known as debt free FCF = EBIT less: Taxes Increase/(decrease) in working capital (WC) Capital expenditures (CapEx) plus: Depreciation and Amortization Notice the before interest designation in EBIT Value of Equity = TEV from Operations Net Debt

A DCF typically projects five (5) years of FCF plus a terminal value but it can be longer or shorter

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Terminal Value
The terminal value represents the value of an investment at the end of a period, taking into account a specified rate of interest (perpetuity)
In other words, it looks at a companys cashflow projected infinitely into the future at a particular growth rate There are two (2) generally accepted methods for calculating the terminal value
1. Gordon Growth Model 2. Terminal Multiple

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Terminal Value (cont.)

Wall street utilizes the terminal multiple
Applying a debt-free multiple (typically TEV / EBITDA) to the ending years operating statistic

Apply the LTM multiple if using the cash flow multiple method
Terminal Value = (LTM Multiple from Comps) x (EBITDA)

Certain industries may require the use of Revenue, EBIT or Net Income multiple

The Gordon Growth Model is exactly what the definition of terminal value states
It is a constant rate projected forward - a perpetuity Terminal Value = (Ending Cashflow x (1 + Growth Rate)) / (Discount Rate - Growth Rate) Good sanity check when backed into Terminal Multiple approach

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Cost of Capital
Future cash flows need to be discounted at an appropriate rate in order to calculate present value
PV = FCF / (1 + discount rate)^year DCF = PVFCF(1) + + PVFCF(5) + PV Terminal Value

Cost of capital (aka, discount rate) is an investors required rate of return or opportunity cost for investing in a particular risk profile
That is to say, what return would I require in another investment of similar risk? Higher risk = higher required return

The cost of capital should match the cash flows to be discounted

Leveraged cash flows vs. debt-free cash flows

Common sense is the most important factor in determining the appropriate cost of capital
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Cost of Capital (cont.)

The discount rate is expressed in two (2) basic forms:
(1) Cost of equity (2) Cost of debt Cost of preferred stock is included as a hybrid between the two

Due to the combination of these two (2) types of capital on a companys balance sheet, the discount rate is usually referred to as the weighted average cost of capital (WACC)

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Weighted Average Cost of Capital (WACC)

The WACC represents the required rate of return for the overall enterprise
It is simply a weighted average of the required rates of return for each of the different sources of capital (equity and debt) WACC = [Ke x (E/(E+D)] + [(Kd x (D/(E+D)) x (1-T)]
Ke = cost of equity Kd = cost of debt E = MVE of subject company D = FMV of debt (same as face value unless distressed) of subject company T = tax rate

Company-specific risk
Size risk Key-man risk Business model or projection risk
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Cost of Equity
The cost of equity is calculated using the capital asset pricing model (CAPM) CAPM = Rf + Beta x (RM Rf)
Rf = risk-free rate (10, 20 or 30 year treasury notes) RM = market rate (Expected return on the market portfolio) RM Rf = market risk premium (return above the risk-free rate)
Calculated by taking an average of data points over many years in order to incorporate a large sample of events Most banks get this rate from Ibbotson Associates (source for risk premium)

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Cost of Equity (cont.)

Beta is the measure of volatility, or systematic risk, of a security compared to the market as a whole (e.g. S&P 500)
Beta of 1 signals that 1% rise in the market translates into 1% rise in the stock Beta of -1 signals that 1% rise in the market translates into 1% decline in the stock

Betas outside of a range of 0.5 to 2.5 should be reviewed for reasonableness Firms use 2 year betas to 5 year betas

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Cost of Equity (cont.)

Levering and un-levering beta
Beta is a function of risk affected by leverage In order to make an apples to apples comparison among company returns, leverage needs to be removed from beta The un-levered beta (mean) should be re-levered with the subject companys capital structure (i.e. debt to equity ratio)
BL = Bu x [1 + D/E x (1-T)] Bu = BL / [1 + D/E x (1-T)]
BL = Levered Beta Bu = Unlevered Beta T = Tax Rate D = Market Value of Debt E = Market Value of Equity

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Cost of Debt
Similar to the cost of equity, the cost of debt represents the return a lender would require in a security of similar risk
All things being equal, the cost of debt is lower than the cost of equity for the following two (2) reasons:
(1) Senior to equity less risk and therefore less required return (2) Interest is paid out before taxes

Under certain situations where a company is over-levered, raising debt may be more expensive due to default risk

There are two main categories of debt which may be valued separately
Non-convertible debt (includes capital leases) Convertible debt, which can be treated as equity if the convertible is in-the-money and as debt if it is out-of-the-money

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Cost of Debt (cont.)

A companys overall cost of debt is calculated by averaging (weighted) the coupon rates of its various pieces of debt and multiplying it by the tax shield (1 - tax rate)
$500M of 8.25% senior notes due 2010 $250M of 9.00% senior notes due 2012 $300M of 12.5% senior subordinated notes due 2012 Tax rate of 40% Cost of debt = 9.64% x (1-.40) = 5.79%

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Homework
Best Buy Co., WACC example Best Buy Co., DCF example

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Table of Contents
I. Valuation Overview II. Comparable Public Companies III. Precedent Transactions V. Discounted Cash Flow (DCF) Analysis VI. Conclusions

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Conclusions
Pros
Highly efficient market Easy to find information (public access) Arguably, the most accurate method

Cons
Size discrepancy Liquidity difference Hard to find good comps in niche market

Comparable Public Companies

Precedent Transactions

Poor disclosure on private and small deals Hard to find good comps in niche or slow M&A market Highly sensitive to discount rate and terminal multiple Hockey Stick tendencies projection risk

Discounted Cash Flow (DCF)

Represents intrinsic value

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