Valuation

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

What Is Valuation?

How much is independent Food Processor 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.

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

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:

This is the Public Market Valuation

(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)

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

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 = ?

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?

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

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:

Industries
Business Models
Profitability
Size
Growth
Geography (International vs. Domestic)

Sources include:

Equity research reports

Competitors section from 10-K
SIC codes
Internet
Senior bankers
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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 * 10.3x =
$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
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9

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:

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9
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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)

1. Weighted-average dilutive shares

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

Located in the EPS note of the notes section

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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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
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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
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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
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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
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9

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.)

H.J. Heinz 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
IV. Discounted Cash Flow (DCF) Analysis
V. Conclusions

23

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:
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9

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
9

Product expansion, cost synergies, technology integration, etc.

What are the financial decisions for this acquisition

9

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

What is the consideration and structure

100% cash
100% acquirers stock
9

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

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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
9

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
IV. Discounted Cash Flow (DCF) Analysis
V. Conclusions

28

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

Estimate Cost of
Capital

Estimating
Terminal Value

Calculating
Results

Identify
components of
FCF
Keep in mind
historical figures
Project
financials using
assumptions
Decide # of years
to forecast

Perform a
WACC analysis
Develop target
capital
structure
Estimate cost of
equity

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

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

CONS

Objective framework for

assessing cash flows and
risk
Not dependent upon
publicly available
information

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

36

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)

37

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)]
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9
9
9
9

BL = Levered Beta
Bu = Unlevered Beta
T = Tax Rate
D = Market Value of Debt
E = Market Value of Equity

39

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%

41

Homework
Kraft Foods, Inc., WACC example
Kraft Foods, Inc., DCF example

42

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

43

Conclusions
Pros

Comparable
Public Companies

Highly efficient
market
Easy to find
information (public
access)

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

Arguably, the most

accurate method

Poor disclosure on
private and small
deals
Hard to find good
comps in niche or slow
M&A market

Represents intrinsic
value

Highly sensitive to
discount rate and
terminal multiple
Hockey Stick
tendencies
projection risk

Precedent
Transactions

Discounted
Cash Flow (DCF)

Cons

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