Valuation Fundamentals Explained

Valuation Fundamentals
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Key Valuation Concepts
• What is enterprise value?

• What is equity value?
• What are the primary valuation methodologies?
• What are the pros and cons of each valuation methodology?
What is Valuation?
• Process of appraising the economic worth of a particular asset or company

• Valuation Applications
– Acquisitions: How much should we pay to buy the assets / company?
– Divestitures: How much could we sell our company / division for?
– Public Equity Offerings: For how much could we sell our company /
division in the public market?
Who Needs Valuation?
• Investment bankers
• Equity research analysts
• Salespeople and traders
• Private equity / buyout professionals
• Attorneys
• Restructuring professionals
• Credit analysts
• Corporate business development
• Anyone looking to make an investment decision
Valuation and the Accounting Equation
Net Operating Assets Invested Capital
Operating Assets – Operating = Financial Liabilities – Financial
Liabilities Assets + Shareholders’ Equity
Operating Operating
Operating Liabilities Operating Liabilities
Assets Assets
= Financial = Financial
Liabilities Liabilities
Financial Financial
Assets Assets
Equity Equity
Valuation and the Accounting Equation
Accounting View of Market View of
Balance Sheet Balance Sheet
Cash Operating Cash Operating

Liabilities Liabilities
= Debt = Debt
Operating Operating
Assets Assets
Equity Equity
Off Balance Incremental

Sheet Value Equity
Enterprise Value vs. Equity Value
• Enterprise value (firm value)

– Market value of net operational assets
– Claims on assets from both debt and equity holders
– Equity + net debt
• Equity value (market capitalization)
– Market value of shareholders’ equity
– Enterprise value – net debt
Net
Market Value Debt
of Net Enterprise
Operational Value
Assets Equity Value
Primary Valuation Methodologies
Trading
Comparables
Analysis
Leveraged Transaction
Buyout Comparables
Valuation Analysis
Discounted
Cash Flow
Analysis
Fundamental vs. Relative Valuation
• Fundamental valuation – the intrinsic value of a

company based on its future cash flows
– Discounted Cash Flow Analysis
– Leveraged Buyout Valuation
• Relative valuation – comparing the price of an
asset to the market value of similar assets
– Trading Comparables Analysis
– Transaction Comparables Analysis
Majority vs. Minority Stake
• Minority stake
– Trading Comparables Analysis
– DCF (without synergies)
• Majority stake
– Transaction Comparables Analysis
– LBO
– DCF with synergies (assumes control)
Equity Value → Enterprise Value
Cash (1)
Debt (2)
Enterprise
Value
(firm value)
Equity
Value
(1) Includes cash, cash equivalents and investments.

(2) Includes financial liabilities, debt equivalents, preferred stock and noncontrolling interest.
Calculating Enterprise Value
Problem #1
• Equity value = $100

• Debt = $25
• Cash = $10
• Enterprise Value?
Calculating Enterprise Value
Problem #2
• Equity value = $100

• Debt = $25
• Preferred stock = $40
• Noncontrolling interest = $10
• Cash = $15
• Long term investments = $25
• Enterprise Value?
Enterprise Value → Equity Value
Cash (1)
Debt (2)
Enterprise
Value
(firm value) Equity
Value
(residual claim)

Calculating Equity Value
Problem #1
• Enterprise value = $200

• Debt = $40
• Cash = $25
• Equity Value?
Calculating Equity Value and Share Price
Problem #2
• Enterprise value = $300

• Debt = $50
• Preferred stock = $25
• Noncontrolling interest = $15
• Cash = $30
• Long term investments = $40
• Diluted WASO = 80
• Diluted shares = 100
• Share price?
Diluted Shares Outstanding
• Equity value is defined as share price * diluted shares outstanding

• Diluted shares includes
– Basic shares outstanding plus shares resulting from dilutive securities:
– “In-the-money” stock options
– Warrants
– Restricted stock units
– Performance units
– Convertible debt
– Convertible preferred stock
• Net new shares due to stock options determined using Treasury
Stock Method (TSM)
• Net new shares = (market price – strike) * (# of options)
market price
Treasury Stock Method
• # of options = 20
• Market price = $10.00
• Strike price = $8.00
• Net new shares created?
Answer:
1) Option proceeds received by company = 20 * $8.00 = $160
2) Shares repurchased with option proceeds = $160 / $10.00 = 16
3) Net new shares = 20 – 16 = 4
Alternately, using the formula on the prior page:

Net new shares = ($10.00 – $8.00) * 20 / $10.00 = 4
Valuation Checklist: EQ to EV
− Cash and + Debt and

cash debt
equivalents equivalents
− Long-term
+ NCI
investments
− Non-core + Preferred
assets stock
Enterprise Equity
Value Value
(residual
(firm value)
claim)
Valuation Checklist: EV to EQ
+ Cash and − Debt and

cash debt
equivalents equivalents
+ Long-term
− NCI
investments
+ Non-core − Preferred
assets stock
Enterprise Equity
Value Value
(residual
(firm value)
claim)
Trading Comparables Analysis
Description Pros Cons
• Relative valuation • Market efficiency ensures • Marked-based valuation

methodology that uses that trading values reflect can be skewed during
trading multiples of industry trends, business severe market ups and
comparable companies to risk and market growth downs
value the target company • Valuation based on a few • Assumes peer group as a
• Key trading multiples: easy to calculate inputs whole is correctly valued
– EV / Sales
• Valuation methodology by the markets
– EV / EBITDA
–P/E
based on key statistics • May be comparing apples
relevant to investors to oranges. Truly
comparable companies
are rare
What Earnings Go With Which Value?
Interest
Cash (1)
Income
Interest
Debt (2)
Expense
Enterprise Revenue
Value EBITDA
(firm value) EBIT Equity
Net Income Value
(residual claim)
= Core, continuing
= Continuing
and controlled
Non-Recurring Items
• Earnings must be adjusted for unusual and non-recurring items in order to

assess “normal” operating performance
– Revenue, EBITDA and EBIT must be core, continuing and controlled
– Examples of non-recurring items:
• Gains/losses on asset sales
• Restructuring charges
• Asset write-downs
• Goodwill impairments
• Legal settlements
• These non-recurring items are sometimes detailed in the financial
statements, but can always be found in the notes to the financial statements
and in the “Management’s Discussion and Analysis” section
• Often, these items are found in the notes to the financial statements, under
“other income/expense” and are only shown on a pre-tax basis
– If the after-tax basis is not shown, one must calculate the after-tax effect on net
income assuming the marginal tax rate, which varies by country
Valuing a Target using Trading Comps
Company Enterprise Value EBITDA
Coca-Cola $194.5B $13.2B
Pepsico $143.1B $12.1B
Dr. Pepper Snapple $11.9B $1.3B
Frosty Beverages ? $2.0B
What is the implied enterprise value of Frosty Beverages?
P/E Multiple
• Price to earnings multiple (most common equity multiple)

• Share price / diluted EPS
Net income available to common / diluted WASO
Consolidated net income

Less: Noncontrolling interest income
Less: Preferred dividends
= Net income available to common
Enterprise Value vs. Equity Value Multiples
Scenario 1 Scenario 2 Scenario 3
Enterprise value 5,000 5,000 5,000
+ Cash 0 800 200
- Debt 0 (200) (1,500)
Equity value 5,000 5,600 3,700
Revenue 2,000 2,000 2,000

- Operating expenses (800) (800) (800)
EBIT 1,200 1,200 1,200
+ Interest income @ 2% 0 16 4
- Interest expense @ 5% 0 (10) (75)
Profit before taxes 1,200 1,206 1,129
- Taxes @ 35% (420) (422) (395)
Net income 780 784 734
EV / revenue 2.5x 2.5x 2.5x

EV / EBIT 4.2x 4.2x 4.2x
P/E 6.4x 7.1x 5.0x
Uses of Common Multiples
Multiple Comments
• EV / Revenue • Useful for companies with little to no earnings (e.g., tech start up)
• Largely used as sanity check on EV / EBITDA
• Not as relevant since cash flow and profitability not taken into account
• EV / EBITDA • Serves as valuation standard in most sectors

• Independent of capital structure and taxes
• Independent of differences in D&A (e.g., one company spent heavily on
capex vs. another, acquisition-related amortization)
•P/E • Most widely recognized trading multiple

• Particularly relevant for mature companies with stable earnings growth
• Not relevant for companies with little to no earnings
• Dependent on capital structure
• Higher P / E’s usually correspond to higher earnings growth
expectations
Transaction Comparables Analysis
• Relative valuation • Analysis based on actual • Past transactions may not

methodology based on acquisition multiples and reflect prevailing market
multiples of selected M&A control premiums conditions
transactions in the same • Recent transactions • Since each transaction is
industry as the target reflect prevailing M&A and unique, we may not know
company being valued capital market conditions all the factors and motives
• In general, produces a • Trends such as foreign that went into the
higher valuation than purchasers or financial formulation of the
trading comparables due buyers may become clear purchase price
to the premium paid for • Transaction multiples
majority acquisition often suggest a wide
range of values and must
be used with care
• May be comparing apples
to oranges. Truly
comparable transactions
are rare
Valuing a Target using Transaction Comps
Acquirer Target EBITDA Multiple
Pepsico Naked Juice 13.0x
Coca-Cola Odwalla 15.8x
Pepsico Wimm-Bill-Dann 19.9x
What is the implied enterprise value of Frosty Beverages assuming

EBITDA of $2.0B and how does this compare to the value derived via the
trading comps methodology?
Discounted Cash Flow Analysis
• Intrinsic valuation • Theoretically the most • Present values obtained

methodology based upon sound method if one is are highly sensitive to key
Company’s future cash very confident in the assumptions (growth
flows and terminal value projections and rates, margins, WACC,
• Discount projected free assumptions since DCF is exit multiple)
cash flows and terminal a cash-flow based • Accurate forecasting of
value at cost of capital to methodology financial performance is
obtain enterprise value, • Particularly important challenging, especially in
then subtract net debt to when no “pure play” the outer years
derive equity value comparable companies • Values obtained can vary
exist over a wide range and
• Allows an expected thus be of limited
operating strategy to be usefulness
incorporated into the
model
• Allows flexibility via
sensitivity analysis
Steps to DCF Analysis
1) Calculate unlevered free cash flows

2) Calculate weighted average cost of capital
3) Calculate terminal value
4) Calculate enterprise value by determining
present value of FCFs and terminal value
5) Solve for equity value and share price
Calculating Unlevered Free Cash Flows
Calculation Comments
EBITDA • Proxy for operating cash flow
– D&A • Need to capture D&A tax shield
= EBIT • Operating profit
– Taxes • Long term effective tax rate * EBIT
= NOPAT • Net operating profit after taxes
+ D&A • Add back non-cash expense
– Capex • Subtract fixed investments
+ / – ∆ in OWC • Add / subtract change in OWC
+ / – ∆ in other • Add / subtract change in other operating items
= Unlevered FCF • Cash flow available to all capital providers
Weighted Average Cost of Capital
• Company’s cost of capital

• Represents blended required return of all stakeholders
(equity and debt)
• WACC represents the risk factor by which future free
cash flows are discounted
WACC = [Ke * E / (D + E)] + [Kd * (1 – T) * D / (D + E)]
Ke = cost of equity
Kd = cost of debt
E= market value of equity
D= market value of debt
T= marginal tax rate
Terminal Value
• Captures value of company’s steady state cash flows after forecast

period (typically 60-80% of company value)
• Terminal year financial performance must represent normalized
levels as opposed to a cyclical high or low
• 2 methods widely used
– Exit multiple method
• Assumes the company is worth a multiple of an operating metric (typically
EBITDA) at the end of the forecast period
• Use either Company’s current LTM multiple (if reasonable) or use LTM
multiple of trading comps as guidance
• Multiple should reflect steady state growth and margins
– Perpetuity growth method
• Assumes the company’s free cash flow in the last forecast year grows at a
constant rate indefinitely
• Growth rate typically in the 2-4% range and should not exceed growth rate
of economy
Calculating Terminal Value
• Exit multiple method
Terminal value = Multiple * Financial Metricn
• Perpetuity growth method

Terminal value = FCFn * (1 + g) / (WACC – g)
FCF = unlevered free cash flow

n= terminal year of projection period
g= perpetuity growth rate
WACC = weighted average cost of capital
Discount Cash Flows and Terminal Value
Terminal Value
FCF 5
FCF 4
FCF 3
FCF 2
FCF 1
Enterprise
Value
Leveraged Buyout Analysis
• An acquisition of a • Will help determine • Standalone LBO will

company in which a realizable financial bidder underestimate strategic
financial sponsor invests value that any strategic sale value by ignoring
a relatively small amount buyer will have to exceed synergies with acquirer.
of equity (compared to the • Useful in identifying Financial buyers tend to
total purchase price) and potential LBO pay lower multiples as
uses leverage to fund the opportunities they are in for a shorter
remainder of the • Estimates the potential term than are strategic
purchase price equity returns to the buyers
• Valuation produces the business, and provides • Value obtained is
maximum price that a sensitivity of the returns to sensitive to projections
financial sponsor would growth, leverage and and aggressiveness of
be willing to pay for a valuation multiple operating assumptions
business and still achieve expansion
its minimum acceptable • Highlights the effects of
IRR adding leverage to the
business
Internal Rate of Return
• Primary metric used to gauge attractiveness of LBO

• Measures total return on equity investment
– Includes additional equity contributions made or dividends received
• Discount rate which equates to a net present value of zero for
all cash inflows and outflows
• 20-25% standard threshold over 3-5 year holding period
• In addition to IRR, another common metric used in LBOs is
the cash-on-cash return
– Example: initial equity of $100M, exit equity of $300M → 3.0x return
– Ignores time value of money
– Also known as multiple-of-money or multiple-of-equity
IRR Calculation
IRR = (Terminal equity value / initial equity investment) ^ (1 / n) – 1
n = number of years investment
• Note: The basic IRR formula does not incorporate cash dividends
that may be paid to equity holders prior to exit. In practice, this is
uncommon as debt covenants typically prohibit dividends to equity
holders prior to debt being paid in full
Example: Purchasing a Home
• Purchase home for $500,000
• Finance purchase with 20% down
• Rent home for 5 years
• Pay off $300,000 debt over 5 years and sell home for $500,000
Purchase: $100K Equity / $400K Debt Sale: $400K Equity / $100K Debt
IRR = ?
LBO Example
Entry Exit (Year 5)
• EBITDA $50 $80
• Multiple 8.0x 8.0x
• Enterprise Value $400 $640
• Debt $300 $100
• Equity $100 $540
What is the IRR?

Drivers of Value in an LBO
• Paying down debt

• Interest tax shield
• Operational improvements
– Grow revenue
– Increase profitability
– Decrease OWC needs
Football Field
Methodology Implied Share Price Relevant Metrics
Reference Points: Current price (5/30/13): $47.08
52-Week High and Low $32.50 $65.70 52-week high (3/10/13) and low (8/17/12)
Equity Research Price Targets $48.00 $59.00 Price targets for 10 research analysts
Comparable Company Analysis $37.05 $45.43 5.0x – 6.0x FY 2013E EBITDA of $415 mm
Precedent Transactions Analysis $62.83 $71.29 8.0x – 9.0x FY 2012 EBITDA of $419 mm
Terminal Multiple: 8.0x

Discounted Cash Flow Analysis $53.80 $66.10 Discount Rate: 12.0% – 14.0%
Max Debt: 5.0x FY2013E EBITDA of $415 mm

Leveraged Buyout Analysis $42.00 $51.00 Entry / Exit multiple range of 6.0x – 7.0x
Implied IRR of 18% – 22%
Share Price: $20.00 $30.00 $40.00 $50.00 $60.00 $70.00 $80.00
Enterprise Value: $1,231 $1,727 $2,223 $2,719 $3,215 $3,711 $4,206
Sample Questions
• What does equity value measure and how do

you calculate it?
• What does enterprise value measure and how
do you calculate it?
• If equity value is 200 and net debt is 10, what is
the enterprise value?
• What is diluted shares outstanding?
• What is the formula for treasury stock method?
Sample Questions (Cont’d)
• Is equity value / EBITDA a common trading

multiple? Why?
• Do trading or transaction comps typically result
in a higher valuation and why?
• Walk me through a DCF
• What is an LBO?
• What are the primary characteristics of a solid
LBO target candidate?

Valuation Fundamentals Explained

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Valuation Fundamentals

• What is enterprise value?

• Process of appraising the economic worth of a particular asset or company

Cash Operating Cash Operating

Off Balance Incremental

• Enterprise value (firm value)

• Fundamental valuation – the intrinsic value of a

(1) Includes cash, cash equivalents and investments.

• Equity value = $100

• Equity value = $100

(1) Includes cash, cash equivalents and investments.

• Enterprise value = $200

• Enterprise value = $300

• Equity value is defined as share price * diluted shares outstanding

Alternately, using the formula on the prior page:

− Cash and + Debt and

+ Cash and − Debt and

• Relative valuation • Market efficiency ensures • Marked-based valuation

• Earnings must be adjusted for unusual and non-recurring items in order to

Company Enterprise Value EBITDA

Coca-Cola $194.5B $13.2B

Pepsico $143.1B $12.1B

Dr. Pepper Snapple $11.9B $1.3B

Frosty Beverages ? $2.0B

What is the implied enterprise value of Frosty Beverages?

• Price to earnings multiple (most common equity multiple)

Net income available to common / diluted WASO

Consolidated net income

Revenue 2,000 2,000 2,000

EV / revenue 2.5x 2.5x 2.5x

• EV / EBITDA • Serves as valuation standard in most sectors

•P/E • Most widely recognized trading multiple

• Relative valuation • Analysis based on actual • Past transactions may not

Acquirer Target EBITDA Multiple

Pepsico Naked Juice 13.0x

Coca-Cola Odwalla 15.8x

Pepsico Wimm-Bill-Dann 19.9x

What is the implied enterprise value of Frosty Beverages assuming

• Intrinsic valuation • Theoretically the most • Present values obtained

1) Calculate unlevered free cash flows

• Company’s cost of capital

WACC = [Ke * E / (D + E)] + [Kd * (1 – T) * D / (D + E)]

• Captures value of company’s steady state cash flows after forecast

• Exit multiple method

Terminal value = Multiple * Financial Metricn

• Perpetuity growth method

FCF = unlevered free cash flow

• An acquisition of a • Will help determine • Standalone LBO will

• Primary metric used to gauge attractiveness of LBO

IRR = (Terminal equity value / initial equity investment) ^ (1 / n) – 1

n = number of years investment

• EBITDA $50 $80

• Multiple 8.0x 8.0x

• Enterprise Value $400 $640

• Debt $300 $100

• Equity $100 $540

What is the IRR?

• Paying down debt

Terminal Multiple: 8.0x

Max Debt: 5.0x FY2013E EBITDA of $415 mm

Share Price: $20.00 $30.00 $40.00 $50.00 $60.00 $70.00 $80.00

Enterprise Value: $1,231 $1,727 $2,223 $2,719 $3,215 $3,711 $4,206

• What does equity value measure and how do