Valuation presentation

Valuation

II BThe Investment Banking Institute

2II BThe Investment Banking Institute


Table of Contents

Discounted Cash Flow (DCF) AnalysisV.

Precedent TransactionsIII.

Comparable Public CompaniesII.

ConclusionsVI.

I. Valuation Overview



What Is Valuation?

How much is Computer Retailer Company A worth? (i.e. what is itsvaluation?)Company A will have different values to different buyersWould the following buyers be willing to pay more or less for a piece of the Company’s 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 company’s 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 company’s 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

This is the “Public Market Valuation”The “Public Market Valuation” provides one perspective on the Company’s valuation: it illustrates at what price minority shareholders are willing to buy and sell the equity shares of that companyIn addition to the Public Market Valuation, there are three methodologies commonly used to derive a company’s 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 valueRecent 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 company’s 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. stockholder’s equity on the balance sheet

MVE ≠ aggregate valueMVE represents only the value from stockholdersWhat 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 leverageThink of real estate to differentiate between TEV and MVE: – House value = TEV; home equity = MVE; mortgage = debt

TEV = MVE + debt + preferred stock + minority interest – cashShare Price = $50.00Shares Outstanding = 200 millionPreferred Stock = $0Debt = $2,000 million Minority Interest = $0Cash = $500 millionTEV = ?



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 liabilityTherefore, 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)



Total Enterprise Value (TEV) (cont.)

Why do we subtract cash in the TEV calculation?Common misconception: cash is netted against debtCash 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




ConclusionsVI.




Comparable Public Companies

You can value a company based on how similar companies trade in the public marketsThe 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



Multiples Analysis

Relative valuation is a method based on applying multiplesA valuation multiple is a ratio between a value and an operatingmetric (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 multiplesOperating (debt-free)Equity

Operating (debt-free) multiplesTEV / Revenue, EBIT or EBITDATEV = $11,500M; Revenue = $19,426M; EBITDA = $1,369MRevenue Multiple = 0.59xEBITDA Multiple = 8.4x



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-freeMVE is value to only stockholders and is affected by leverage

Let’s say our subject company, a widget maker, has annual financials of the following:

Revenue: $19,426 millionEBITDA: $1,369 million

Mean trading multiples for publicly-traded widget companiesTEV / Rev: 0.74xTEV / EBITDA: 10.3x



Operating Multiples (cont.)

What’s is our company’s implied TEV?Revenue: $19,426 millionEBITDA: $1,369 millionImplied TEV using revenue multiple = $19,426 million * 0.74x = $14,375 millionImplied TEV using EBITDA multiple = $1,369 million * 0.74x = $14,101 millionAverage Implied TEV = average ($14,375 million, $14,101 million) = $14,238



Equity Multiples

Unlike operating multiples, equity multiples are a function of MVESince the general public owns common stock and not other types of securities, analysts speak in P/E ratios

Price per Share / Earnings per ShareMarket Cap / Earnings

Again P/E is a function of MVE, which is not a good indicator ofcompany valuationEquity multiples require the denominator to be below the interest line (i.e. net income)

Again, “Apples to Apples”Wrong: TEV / EarningsWrong: Market Cap / EBITDA



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



“Spreading Comps” (cont.)

Calculating TEVAll 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




Calculating Fully-Diluted SharesBasic 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 stockA convertible security or option is “in-the-money” if the current share price is greater than the strike price

– Dilutive securities include:OptionsWarrantsConvertible 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 besizeable




There are two (2) generally accepted methods for calculating dilutive shares 1. Weighted-average dilutive shares assumed by management2. The Treasury Stock Method (TSM)

1. Weighted-average dilutive sharesLooks 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 in-

the-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



“Spreading Comps” (cont.)2. The Treasury Stock Method (TSM)

The net of new shares potentially created by unexercised in-the-money 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 marketTSM = 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 10KFull-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)



“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 securitiesConversion 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 pre-converted and post-converted values of the same security

The conversion of a convertible security into equity means that its pre-converted form can no longer existFor example, if you convert $500 million of convertible debt into dilutive shares, you must remember to remove $500 million from total debt



“Spreading” Comps (cont.)

Best Buy Co. Comp Spread Example



Selecting Multiples and Ranges

Selecting multiples for implied valuationEliminate outliersAverage (mean) vs. medianTotal versus stripped averagesUpper and lower quartiles

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

Identifying meaningful implied valuation rangesNot too narrow, not too broadBe consistent

Public vs. private valueLiquidity discountResearch coverage



Table of Contents




ConclusionsVI.




Precedent Transactions

Another form of relative value is precedent transactionsMany 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

company’s 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 transactionsTarget company characteristicsTransaction parametersTime frame



Precedent Transactions (cont.)

Data sources:SDC or other M&A databasesSEC filingsEquity research reportsPress releases (company or third-party)Industry news

Typical informationAnnounce 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 priceTransaction-related adjustments

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

Target and acquirer descriptions




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

What is the consideration and structure– 100% cash– 100% acquirer’s 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 stockEach share of target company will receive $12.65 in cash and 1.45 shares of acquiring companyWhat is the consideration if there are 24 million target shares outstanding and the acquiring company’s stock price is worth $6.55 at announce date?

– Earn-out provisionsPortion of the consideration withheld until operational milestones are achieved




Typical information (cont.)Implied TEV and MVESelected financial and operating informationImplied valuation multiplesMarket premiums– Purchase price divided by the (i) 1-day, (ii) 5-day and (iii) 30-day

average stock price prior to announce date



Table of Contents




ConclusionsVI.




Discounted Cash Flow Overview

The DCF calculation represents a company’s “intrinsic” valueTakes all cash flows projected into the future (infinitely) and discounts it back to present value

•Identify components of FCF

•Keep in mind historical figures

•Project financials using assumptions

•Decide # of years to forecast

Forecasting Free Cash Flows

•Perform a WACC analysis

•Develop target capital structure

•Estimate cost of equity

Estimate Cost of Capital

• 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

Estimating Terminal Value

•Bring all cash flows to present value

•Perform sensitivity analysis

• Interpret results

Calculating Results



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

•Objective framework for assessing cash flows and risk

•Not dependent upon publicly available information

PROS

•Very sensitive to cash flows

•Unbalanced valuation weight to terminal value

•Cost of capital depends on beta and market risk premium

CONS



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 = EBITless: Taxes

Increase/(decrease) in working capital (WC)Capital expenditures (CapEx)

plus: Depreciation and AmortizationNotice the “before interest” designation in EBITValue 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



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 company’s cashflow projected infinitely into the future at a particular growth rateThere are two (2) generally accepted methods for calculating theterminal value1. Gordon Growth Model2. Terminal Multiple



Terminal Value (cont.)

Wall street utilizes the terminal multipleApplying a debt-free multiple (typically TEV / EBITDA) to the ending year’s 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 perpetuityTerminal Value = (Ending Cashflow x (1 + Growth Rate)) / (Discount Rate - Growth Rate)Good “sanity check” when backed into Terminal Multiple approach



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)^yearDCF = PVFCF(1) + … + PVFCF(5) + PV Terminal Value

Cost of capital (aka, discount rate) is an investor’s required rate of return or opportunity cost for investing in a particularrisk 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



Cost of Capital (cont.)

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

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



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 riskSize riskKey-man riskBusiness model or projection risk



Cost of Equity

The cost of equity is calculated using the capital asset pricingmodel (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)



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% risein the stockBeta 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



Cost of Equity (cont.)

Levering and un-levering betaBeta is a function of risk affected by leverageIn order to make an “apples to apples” comparison among company returns, leverage needs to be removed from betaThe un-levered beta (mean) should be re-levered with the subject company’s 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 BetaBu = Unlevered BetaT = Tax RateD = Market Value of DebtE = Market Value of Equity



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



Cost of Debt (cont.)

A company’s 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 2012Tax rate of 40%Cost of debt = 9.64% x (1-.40) = 5.79%



Homework

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



Table of Contents




ConclusionsVI.




Conclusions

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

Represents intrinsic value

Discounted Cash Flow (DCF)

Poor disclosure on private and small dealsHard to find “good”comps in niche or slow M&A market

Arguably, the most accurate method

Precedent Transactions

Size discrepancyLiquidity differenceHard to find “good”comps in niche market

Highly efficient marketEasy to find information (public access)

Comparable Public Companies

ConsPros

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Valuation presentation

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