Valuation presentation

Valuation

Copyright Investment Banking Institute

www.ibtraining.com

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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

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How Do We Value Companies?

The valuation methodologies we will learn are largely practiced by all types of investors, but there are some differences in practice

Types of investors are: strategic buyers (M&A), active buyers (LBO, venture capital), and passive buyers (mutual funds, hedge funds)

Which of the following buyers would be willing to pay the highest price for shares of a company?.....

A mutual fund seeking to acquire a 1% position

A competitor of that company seeking to buy the whole company, after identifying significant synergies such as cross-selling into its customer base and utilizing the target’s manufacturing facilities which have only 50% capacity utilization

An LBO firm seeking to buy the whole company by taking out a bank loan for 70% of the purchase price, assume an active role in management, achieve better operational efficiency, then sell it in five years

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How Do We Value Companies?

There is the “public market valuation” which is the market cap. But is it a fair valuation? Competent investors perform their own valuation calculation. Has the valuation been hyped or beaten down too much? A major variable in public valuations is the expected growth rate in the future, and the crowd can be wrong.

Both publicly traded and private companies are valued by the same methodologies, unless the investment is a strategic one. In that case, synergies are included in the valuation.

There are three methodologies for valuing companies:

“Comparable public companies” (comparing all peers’ valuations as multiples to financial results, such as the PE multiple, viewed in the context of growth and operating efficiency)

“Precedent transactions” (for M&A- at which multiples were peers acquired in the past? Should our client get a similar price to the last deal?)

“Discounted cash flow” (DCF)

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How Do We Value Companies? To value companies, we need to start with the following data:

Historical income statement (at least the last 5 years)

Historical balance sheet (at least the last 5 years)

Historical cash flow statement (at least the last 5 years)

How many years of data needed depends on how much things are different today, or may be in the future, versus the past. If a cyclical company, we want enough years to capture two up-cycles and down-cycles. We also want financial results during the last recession and boom.

We then make projections for each financial statement….based on historical data and trends if there are any, and on what we expect about the company’s and sector’s future. Do not assume the past is entirely a guide to the future. Judgment is a big part of making projections.

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Total Enterprise Value (TEV)

“Total enterprise value” accounts for debt and cash in the valuation.

Think of a real estate example….. Home value = total enterprise value Your equity = market cap Your mortgage = debt If you buy a home for $500K and take out a mortgage for $400K, your

equity is $100K

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

Institutional investors will sometimes simply use “EV” of market cap +

debt – cash, but the more accurate calculation is TEV. Many companies don’t have preferred stock or much minority interest, which is why many use the shorthand calculation.

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Why is minority interest added to the calculation?

Minority interest is when a company owns more than 50% but less than 100% of another company. FASB requires that you consolidate the financials at and above the operating income line, and include an offsetting “minority interest” line below operating income representing the portion of financial results you owe to whoever owns the other 1% - 49%.

The TEV/Revenue valuation multiple is what’s called an “unlevered multiple”. The P/E is a “levered multiple” because the “E” includes interest expense.

Since the minority interest revenue is consolidated in revenue but not 100% owned, we add the minority interest to TEV for the TEV/Revenue valuation multiple.

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Why is cash subtracted from TEV?

If you had the chance to buy either of these two companies, assuming all else were equal, same market cap, same EBITDA, same profit margins, same growth rate, which would you buy? Company A has $100 million in cash, no debt Company B has $20 million in cash, no debt

Company A’s TEV will be lower, hence a lower TEV/EBITDA valuation multiple. You pay the same for the equity of each (same market cap), but you get more for your money with company A because you get its cash.

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V. Conclusions

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Comparable Public Companies

You can value a company based on how similar companies (“comps”) trade in the public markets

The first step is to identify 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 for finding comps include….. Equity research reports, “Competitors” section from 10-K, SIC

codes, Internet, senior bankers

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Multiples Analysis

Multiples analysis is a form of “relative valuation”, we compare many companies to each other based on valuation multiples.

The most commonly used multiples are TEV / EBITDA (a very important one) TEV / Revenue TEV / Unlevered Free Cash Flow Market cap / Free Cash Flow (Free Cash Flow = operating cash flow minus capital expenditures) Stock Price per Share / Earnings per Share (the PE)

Any multiple based on TEV is called an operating multiple (unlevered)

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Operating Multiples

Why is TEV multiple an operating multiple, and unlevered?

The TEV includes the leverage, yes, but the denominators do not. They exclude interest expense (such as EBITDA). We do not want to double count the debt factor.

When comparing many companies’ valuations, we use the TEV not just to account for debt, but to give credit for the cash a company has.

All denominators for TEV multiples are operating income and higher on the income statement. Never use a TEV to net income ratio, it double counts the debt because net income includes interest expense.

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Operating Multiples

What if our client is a private company, how can we determine

its valuation based on multiples?

What if we know the following…. Revenue = $19 billion EBITDA = $2 billion Its peer group has a median “TEV / Revenue” of 0.74x and

median “TEV / EBITDA” of 10.3x

The “implied” TEV for our privately held client would be what?

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Equity Multiples

Unlike operating multiples (TEV), equity multiples are a

function of MVE (market cap). PE is the same as market cap / net income.

Equity multiples use denominators that include interest expense. Never use a simple Market Cap/EBITDA or Market Cap/Revenue multiple

What are the flaws with PE ratios? What falls below the operating income line that can make comparisons between companies flawed?

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“Spreading Comps”

The term “spreading” comps comes from “spreadsheet”. It means filling out financial data for all comparable companies to compare ratios to each other.

Use the same time frame for each company. Include a “last twelve months” column.

Remember that different companies have different fiscal year ends. Line them up as closely as possible calendar-wise.

Add a line to normalize results, stripping out non-recurring items and discontinued operations.

Include projections, which you may make yourself, or use estimates from equity or credit research analysts. Many will start with other analysts’ estimates, and then tweak them.

Remember that past performance is not always a guide to future performance.

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Emphasize the TEV multiples in the comp sheet, and use fair

market value (“FMV”) for each component….. MVE = market cap (“market value of equity”)

FMV of preferred = public market price

FMV of debt = use the balance sheet value, unless distressed use market value

FMV of minority interest = use the balance sheet value

FMV of cash = use the balance sheet value

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Calculating Fully-Diluted Shares

Basic vs. Diluted Shares Outstanding – Dilution is built into the stock price – If dilutive securities are “in-the-money”, market assumes that they’re

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…. – Employee Options (not traded on market), Warrants, Convertible

Preferred or Debt (do not double-count if already converted)

Market Cap and TEV should always be calculated using diluted shares – Using basic shares will undercut the valuation, sometimes significantly – In certain industries where options are a large part of employee

compensation, the amount of dilutive shares can be sizeable

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Diluted shares as disclosed in company filings is by the

“Treasury Stock Method”. You will need to know how to calculate this yourself, because when a company is acquired, unvested stock options may become vested. Those unvested options were not included in FD shares in prior filings.

Weighted-average diluted shares Weighted for average balance over a time frame Includes in-the-money warrants, options, convertibles These are also called “common stock equivalents” (CSEs) Used in the calculation of diluted EPS May not equal the very latest amount of dilutive securities

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The Treasury Stock Method

Let’s say there are options for 50,000 shares and avg exercise price of $50. When exercised, company receives cash of $2.5 mil.

Company then uses the $2.5 mil to buy as many shares on open market to deliver. If stock price is $125, it can buy 20,000 shares.

It then has to come up with another 30,000 shares to meet obligation of 50,000 shares. It issues those 30,000 shares, maybe out of treasury stock.

The dilution is then 30,000 shares (not 50,000 shares)

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“Spreading Comps” The Excel formula for the Treasury Stock Method is….. = Exercisable options outstanding x (stock price – exercise price) / stock price Exercisable options are found in the options table in the notes

section of the 10-K. Hit CTRL-F and use “exercise” or “option” as the search word, hit enter until you find it.

Exercisable options are only those that are vested.

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The Treasury Stock Method does not include in-the-money convertible preferred or convertible debt. This must be calculated separately, and should be included in diluted shares as well.

These are CSEs (common stock equivalents) too. When converting them to equity equivalents for the diluted calculation, the diluted EPS calculation must also exclude the interest or dividends paid on those convertibles.

Convertibles have “conversion features” that set how many shares each bond converts to. These are found in the indentures, sometimes in the 10K. If a $1,000 convertible bond converts to 100 shares, you will want to

convert only when the stock price is at least $10 plus the interest income. 100 shares * $10 = $1,000. So if the stock price is at $12, it’s “in-the-money”.

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H.J. Heinz 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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V. Conclusions

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Precedent Transactions

Another method of “relative valuation” is by precedent transactions (M&A) This is especially used in M&A, whereby an argument is made that

the client should fetch a price similar to recent buyouts of comparable companies.

This is also a multiples based valuation

The amount a company is bought for in excess of its stock price per share is called the “control premium”

Typical premiums are 20%-25%, but can be much higher or lower depending on synergies and the strategic fit

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

Typical information you will find: Target and acquirer descriptions 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 due to change in target or acquirer stock price, or transaction-related adjustments

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

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Additional typical information one should keep records of and use:

Transaction rationale – What were the motives? Was it to expand the product line, cross-

selling, cost synergies? Were there mostly financial considerations such as the company being under-valued, poorly run, not capitalized properly?

Implied TEV and MVE, implied valuation multiples, premiums paid over avg. stock price 1, 5, 30 days prior to announcement date

The deal structure – Were there earn-out provisions whereby a portion of the consideration

is withheld until operational milestones are met? – Was a portion of the consideration placed in escrow contingent on all

disclosures being correctly made?

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And lastly, one of the most important stats…..

The total consideration paid 100% cash? 100% stock? Combination of cash and stock?

What if Shareholders of target get $12.65/share cash, AND 1.45 shares of the acquirer, how much is the acquiring company paying? We would also need to know how many shares outstanding are

there of the target, and stock price of the acquirer If target has 24 mil shares outstanding, and the stock price of the

acquirer is $6.55/share.......... what is total consideration paid?

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Solution for total consideration paid: $12.65/share in cash * 24 mil shares = $304 million cash

1.45 shares * 24 mil shares = shareholders of target get 34.8

mil shares of acquirer.

What’s that worth in dollars? 34.8 * $6.55/share = $228 mil worth of acquirer’s stock

$304 million cash + $228 million stock = $532 million “total consideration”

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What if we already know the consideration paid (usually the case) and we want to calculate the exchange ratio? Assume we know the following……

$48/share offer price Mix of cash/stock is 20% cash, 80% stock Target’s shares outstanding are 381.7 million Acquirer’s stock price $26.67

What is the exchange ratio?

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Calculate the per share amount of the $48 dollar offer price…

Target’s shareholders get 20% * $48 = $9.60/share in cash, therefore $48.00 - $9.60 = $38.40/share in stock of the acquirer

Convert that per share cash and stock to dollar values…$9.60/share * 381.7 (target’s shares outstanding) = $3,664 cash, $38.40/share * 381.7 = $14,657 in the acquirer’s stock

Now…how many shares of stock does the acquirer have to offer the target?

$14,657 in acquirer’s stock / $26.67 (acquirer’s share price) = 549.6 shares of the acquirer’s stock to the target’s shareholders

Finally, what’s the exchange ratio based on that? 549.6 acquirer shares / 381.7 target shares = 1.44x exchange ratio.

The acquirer has to offer 1.44 share of its own stock for every 1 share of the target’s shares outstanding

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V. Conclusions

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Discounted Cash Flow Overview

The DCF calculation represents a company’s “intrinsic” value

Takes all cash flows projected into the future (infinitely) and discounts them back to present dollars

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 “EBITDA multiple” or “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) is used in DCF valuations. More scientific method of valuing future operating results because

of differences in GAAP and cash flow. A large capex expense next year will produce a much different

present value than its 10-year straight line depreciation expense over 10 years.

There is levered and unlevered FCF……

“Unlevered FCF” = EBIT + D&A – taxes – increase (or + decrease) in working capital – capital expenditures

“Levered FCF” = Net income + D&A – increase (or + decrease) in working capital – capital expenditures

“Levered FCF” is otherwise simply: operating cash flow – capex

Only difference is that unlevered FCF excludes interest expense. It is independent of the capital structure.

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Discounted Cash Flow (DCF) Analysis

A DCF can use free cash flow projections anywhere from 5 years to 10 years in the future. An early stage company (venture capital) may even use 12 years.

When making projections, remember that recessions do occur, and while we do not know when in the future, one must make assumptions that conditions will not always be good.

When making projections, one must bear in mind that cycles do occur, and to capture at least one up-cycle and down-cycle, if the company is a cyclical. How long are the cycles? Aerospace has long cycles, Semiconductor short cycles.

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Terminal Value

DCF first discounts to the present value each year of annual projections. A dollar in 10 years should be worth more than today because you can invest it, therefore a dollar in 10 years would be worth less in present day dollars.

The largest component of the DCF valuation is the “terminal value”

Companies are valued “in perpetuity”. The terminal value gives the

company credit for likely still being in business beyond, say, year 10 of a 10-year cash flow projection.

The terminal value uses one of the following methodologies to calculate the “perpetuity” portion of the DCF….

Gordon Growth method Terminal Multiple method

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Terminal Multiple v. Gordon Growth

The “terminal multiple” method’s terminal value = an assumed TEV/EBITDA multiple at the final year of the projections, and then discounts that back to present dollar values.

The “Gordon Growth” method’s terminal value = final year’s FCF multiplied by (1+G), then divided by (R – G), then discount that to the present by taking that result and divide by (1 + R) ^ year

Whereby….. R = discount rate (same as cost of capital) G = Projected long-term growth rate ^ = to the power of (exponent) Year = how many years in the future is the final year’s FCF

projection times (1+G), which is one year past the final year of the annual projections.

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Cost of Capital

Each year’s FCF projection and the terminal value will be discounted back to present day by (1 + R) ^ year

R = discount rate = cost of capital (all are synonyms)

It is also called “cost of capital” because it is both a measure of risk, and takes into account where else we could we invest given the level of risk.

If you invest in something as riskless as a 3-month US Treasury, your discount rate used = the interest rate of the 3-month T-Bill.

If you invest in a biotech as risky as something where you stand to lose all your money, you may use a discount rate as high as 35%.

Venture capital uses very high discount rates

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Cost of Capital

The discount rate is comprised of two types of capital: Cost of equity Cost of debt Cost of preferred stock, if any

Because most companies have some debt, the discount rate is called the “weighted average cost of capital” because one needs to weight each component according to its proportion in the capital structure.

The formula to weight the components is:

WACC = (cost of equity * (mkt cap / (mkt cap + debt)))

+ (cost of debt * (debt / (mkt. cap + debt)) * (1 – tax rate)))

Now, how do we calculation the cost of equity and cost of debt? ……..

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Cost of Equity

The cost of equity is typically calculated by a formula called “the capital asset pricing model” (CAPM, pronounced “cap – m”)

Cost of Equity = risk free rate + beta * (avg. stock mkt. return – risk free

rate) Risk free rate is the US treasury of a duration similar to how long you

plan to invest, how liquid is the investment. If passive investing in a public stock that you can sell anytime, use 3-month T-Bill. If an LBO firm planned to buy and sell a company in 5 years, they may use the 5-year US Treasury.

The Average stock market return is debatable because a lot has changed in recent years. Investors used to use a 12% S&P return over the last 40 years. One may use judgment in selecting this rate.

And what is the beta? ………

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Cost of Equity – the “Beta”

(stock mkt. return – risk free rate) is otherwise known as the “risk premium”.

The “risk premium” is multiplied by a “beta”

“Beta” is the measure of risk and the largest variable in the calculation. It is obtained from a data service like Bloomberg or Ibbotson, and technically it is a calculation of how much a stock has gyrated with the overall stock market.

A beta of 1.2x means the stock, over some period of time, 2 years, 5 years, has gone up $1.20 for every $1.00 rise in the market, and fallen by $1.20 when the market goes down $1.00.

High beta = high risk (but potentially, high reward as well)

Use your judgment, think. A beta from data over the last 5 years may not be appropriate if a lot has changed with the company recently. Or maybe it has become less risky.

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Cost of Equity – Levering & Unlevering Betas

Levering and un-levering betas…..

The betas you obtain from Bloomberg are “levered betas”. This means they include the entire capital structure.

If a client is a private company, or if it will recapitalize, you need to un-lever the beta, and then re-lever it for the company’s own capital structure. If private company, you would take median levered beta of peers which may have radically different debt/equity proportions, un-lever it, then re-lever it.

Formula to un-lever a beta:

“Unlevered beta” = levered beta / (1 + D / E) * (1 – tax rate)

Formula to re-lever a beta:

“Levered Beta” = un-levered beta * (1 + D / E) * (1 – tax rate)

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Cost of Debt

Cost of debt is the after tax weighted average interest rate a company pays for its debt. If weighted average is 9%, cost of debt is 9% * (1- tax rate).

It is lower than the cost of equity because it carries less risk, it is more senior in the capital structure and more likely to recoup its money if the company liquidates.

Cost of debt rarely will be higher than cost of equity because lenders will simply not lend more if it gets too risky, if the company has already taken on a lot of debt.

To weight the overall interest rate, break out all debt tranches, and weight according to how much each is as a percent of total debt. Then multiply each tranche’s interest rate by that weighting percentage. Add them up.

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Cost of Debt

Calculate the average (weighted) of the coupon rates of each tranche of debt, and multiply that by the tax shield (1 - tax rate)

First sum all debt. Then multiple each tranche’s amount by sum of all debt. Then multiply each weight by each respective coupon rate. Then sum all weighted coupon rates. That’s the cost of debt.

$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

Kraft Foods WACC example

Kraft Foods DCF example

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Table of Contents





V. Conclusions

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Pros and Cons of 3 Valuation Methods Pros Cons

Comparable Public Companies

Highly efficient market

Easy to find information (public access)

Size discrepancy

Liquidity difference

Hard to find “good” comps in niche market


For M&A, arguably, the most accurate method

Poor disclosure on private and small deals

Hard to find “good” comps in niche or slow M&A market

Discounted Cash Flow (DCF)

Represents intrinsic value

Can make own projections

Highly sensitive to discount rate and terminal multiple

“Hockey Stick” tendencies – projection risk