My own notes about Investment banking course taught by University of Illinois at Urbana-Champaign on Coursera
- Investment-banking-Financial-analysis-and-Valuation-Coursera
- Module 1
- Module 2
- Module 3
- Module 4
- Fundamental concept in valuation is comparability: Between periods/points of time; Across companies.
- Create a financial spread;
- Assemble financial data in a consistent format;
- General company information
- Market data
- Balance sheet data
- Income statement (reported/adjusted)
- Fully diluted shares
- Trading multiples/growth rates
- SEC Filings - Historical financial data (public)
- Audited Financials - Historical financial data (public and private)
- Proxy statements - Share data (public)
- Bloomberg, Capital IQ, Yahoo finance - Market data
- Multiples may be based on past performance or future expectations
- LTM = Latest twelve months = past performance;
- NFY = Next fiscal year = future expectations for the next year-end;
- NFY + 1 = One year after the next fiscal year end;
- Equity Value (Market Capitalisation) + Total Debt Securities + Preferred Stock + Noncontrolling Interest - Cash and Cash Equivalents = Enterprise Value (EV)
- Total debt securities minus cash and cash equivalents = net debt.
- Equity Value = Market Capitalisation = Stock Price * Fully Diluted Shares Outstanding
Common Equity Value Multiples:
- Equity Value/Net Income - Price/Earnings
- Equity Value/Book Equity Value - Price/Book
Derived by dividing enterprise value by specific metric:
- EV/Revenue
- EV/EBIT
- EV/EBITDA
A company with good prospects for profitability and growth should trade at a higher multiple than its peers.
- Always use fully diluted shares;
- Dilution is built into a company's stock price: The market accounts for the impact of dilutie securities;
Financial instruments that if exercised would reduce, or "dilute" basic EPS (earnings pershare). Most common:
- Stock options
- Warrants
- Restricted stock units (RSUs)
- Convertible preferred stocks
- Convertible bonds
Treasury stock method used to determine dilutive impact
- Assume that all "in the money" options and warrants exericsed.
- Exercised shares are added to basic shares.
- Money received from exercise are used to repurchase shares.
- Repurchased shares become treasury stock and reduce basic shares.
- Net of shares exericsed, and shares repurchased is dilutive impact.
- Grant price = price of stock at date of grant
- Current price = price of stock today
- "In the money" = Current > Grant
- "Out of the money" = Current < Grant
- Treated as stock options with a grant price of zero
- Total amount of RSUs treated as dilutive securities.
- Look at conversion price/ conversion ratios to determine number of shares.
- Fully diluted shares outstanding = Basic shares outstanding Options/ Warrants - net addition(TSM) + RSUs (all) + Convertible securities(outstanding * conversion rate)
- The Income Statement and the Cash Flow Data show up in the "Reported Financial Data" section of the spread template.
- Records three years of historical data and the latest twelve months.
- DO NOT modify the form of the template; conform the company's presentation to fit the template line items.
- Shows year-to-date (YTD) financial data
- Use to derive latest-twelve-month (LTM) financial data
- LTM = Current stub + Prior year - Prior stub
- Not every company has the same year-end date
- Most are 12/31; but many are not.
- Important to convert all companies being analysed to same year-end
- Many historical financial statements are not "clean": - One-time charges; Extradordinary items.
- Other times the financial presentation is not "comparable" between companies.
- Reminder: Comparability/standardisation of data is key.
- Severance expense: not expected to happen every period.
- Gain on sale of a building: Don't do it often; unrelated to operations.
- Look on the face of the Income Statement
- Do a search for Key Words in 10-K and 10-Q
Valuation is both an art and a science
- The art is picking the best comparables and normalising financial statements which requires judgement.
- The science is that the models and valuation techniques used all follow the same established corporate finance frame works.
Valuation analysis has many applications
- M&A
- Public offerings
- Restructurings
- Investment decisions
For companies listed on stock exchange
- Share Price
- Public Research
Stock price - moment in time
- True value does not fluctuate each day
- Perform analytics to assess valuation ranges
- Market-Based Valuation Multiples: Public Company Comparables Analysis "Public Comps" and Precedent Transactions Analysis "Transaction Comps"
- Future Cash-Flow Based: Discounted Cash-Flow Analysis "DCF" and Leveraged Buyout Analysis "LBO"
- Never rely on just one approach.
- Stock Price * Fully Diluted Shares Outstanding = Market Value of Equity or "Market Capitalisation".
- Market Value of Equity + Total Debt Preferred Stock Non-Controlling Interest - Cash = Total Enterprise Value "TEV".
- Total Enterprise Value / Normalised Latest Twelve-Month EBITDA = Implied Valuation Multiple TEV/LTM EMBITDA.
- Implied Valuation Multiple TEV/LTM EBITDA * Adjusted LTM EBITDA of Business Being Valued = Implied Total Enterprise Value for Business Being Valued.
Premise: Similar companies are hightly valuable reference points for valuation; share common:
- Operating and financial characteristics;
- Performance drivers;
- Business and environmental risks.
Considered a "current" valuation.
"Good", but not "perfect"
- Current market valuation levels may be historically high or low.
- No two companies are exactly the same.
- Study the business you are valuing and select a list of comparable companies;
- Locate the necessary financial information;
- Review key statistics to select the right universe of companies to spread;
- Spread and benchmark the selected comparable companies;
- Calculate valuation statistics and apply them to the business you are valuing.
- Inputs: 10k Filings; 10q Filings; Stock Price; For Subject Company and Comparables
- To: Spread Template: Fully diluted share calculation; Make adjustments; LTM calculations
- Output: Benchmarking Output and Valuation Output
- Market Based - Information used to derive valuation for target is based on actual public market data, reflecting the market's growth and risks, as well as overall sentiment.
- Relativity - Easily measurable and comparable versus other companies.
- Quick and Convenient - Valuation can be determined on the basis of a few quick-to-calculate inputs.
- Current - Valuation is based on prevailing market data, which can be updated on a daily basis.
- Market Based - Valuation that is completely market-based can be skewed during periods of irrationality in the market.
- Absence of relevant comparables - "Pure play" comparables may be difficult to identify or even nonexistent, especially if the target operates in a niche market.
- Potential disconnect from cash flow - Valuation based on prevailing market conditions or expectations may have significant disconnect from the valuation by a company's projected cash flow generation.
- Company-specific issues: Valuation of the target is based on valuation of other companies, which may fail to capture target-specific strengths, weaknesses, etc.
- Market-based: Trading price for public comps; Acquisition price for transaction comps
- Multiples-based: Judgment is required to select comparables and financial information; Spreading and adjusting financial information is virtuallly identical.
- Public comps are based on a current trading price and current financial results.
- Transaction comps are based on an acquisition price when the deal was announced and on financial information at the time of transaction, so transaction comps are "historical".
- Transaction comps tend to focus more on historical(latest twelve month) multiples while public comparables provide historical and projected multiples.
- Transaction comps reflect a "change of control" premium while public comps reflect a minority interest valuation.
- Transaction comps can also reflect synergies (if a strategic buyer) and potentially tax benefits resulting in higher valuation multiples.
- Acquisition premiums can be calculated on transaction comparables when the target company is public at the time of acquisition.
- Once transaction comps are spread, they do not need to be updated whereas public comps need to be updated as the stock price changes and new filings become available.
- Find and select comparable acquisitions;
- Locate the necessary deal-related and financial information;
- Spread and adjust financial and transactional information;
- Benchmark comparable acquisitions against the company you are valuing;
- Determine a reasonable range of implied valuation.
- Screen for comparable acquisitions
- Initial goal when screening for comparable acquisitions is to locate as many potential transactions as possible for a relevant, recent time period and then refine the universe.
- Sources for Creating an Initial List of Comparable Acquisitions: Search M&A databases; Examine target's M&A history; Revisit target's universe of comparable companies; Search merger proxies for comparable acquisitions; Review equity and fixed income research reports.
- Fully diluted shares and total enterprise value calculations.
- Different forms of consideration: Cash, Shares of acquiring company and Combination.
- Calculation of premiums paid.
- Impact of synergies.
- In a transaction, RSUs and "outstanding" versus just "exercisable" options should be factored into fully diluted shares.
- Debt pre-payment penalities might need to be added to debt balances in a transaction comp as well.
- Cash: OfferPrice * Fully Diluted Shares Outstanding = Equity Value;
- Stock (Shares of acquirer's stock): (Exchange Ratio * Acquirer's Share price) * Fully Diluted Shares Outstanding = Equity Value;
- Cash and Stock: (Cash Offer Price Per Share + Exchange Ratio * Acquirer's Share) * Fully Diluted Shares Outstanding = Equity Value.
- Offer Price Per Share / Unaffected Share Price - 1 = % Premium Paid.
- Enterprise Value / LTM EBITDA
- Enterprise Value / (LTM EBITDA + Synergies)
- Market-based: Analysis is based on actual acquisition multiples and premiums paid for similar companies.
- Current: Recent transactions tend to reflect prevailing M&A, capital markets and general economic conditions.
- Relativity: Multiples approach provides straightforward reference points across sectors and time periods.
- Simplicity: Key multiples for a few selected transactions can anchor valuation.
- Objectivity: Precedent-based and therefore, avoids making assumptiosn about company's future performance.
- Market-based: Multiples may be skewed depending on capital markets and/or economic environment at the time of the transaction.
- Time-lag: Precedent transactions, by definition, have occurred in the past and, therefore, may not be truly reflective of current market conditions.
- Difficult to find: In some cases, it may be difficult to find a robust universe of precedent transactions.
- Availability of information: Information may be insufficient to determine transaction multiples for many comparable acquisitions.
- Acquirer's basis for valuation: May be based on buyer expectations regarding the target's future financial performance rather than reported LTM financial information.
- Intrinsic vs a market-based valuation technique.
- Premise: Value of a company can be derived from the present value (PV) of its projected free cahs flow (FCF).
- Key inputs: Sales growth rates, Profit margins, Capital expenditures, Net working capital (NWC) requirements.
- Projected in detail for typically five years. Could be more for high growth / early stage companie.
- Terminal value is used to capture the remaining value of the target's free cash flow beyond the projection period.
- Projected FCF and terminal value are discounted to the present at the target's weighted average cost of capital (WACC).
- Sum of present value (PV) of the projected FCF and terminal value = enterprise value.
- Study the Target and Determine Key Performance Drivers.
- Project Free Cash Flow.
- Calculate Weighted Average Cost of Capital.
- Determine Terminal Value.
- Calculate Present Value and Determine Valuation.
- Focus on Unlevered Free Cash Flow (UFCF).
Cash generated by a company after
- Cash operating expenses
- Cash taxes (NOT income statement taxes)
- Capital expenditures
- Changes in working capital
- Before interest expense (capital structure neutral)
- Earnings Before Interest and Taxes
- Last: Taxes (at the Marginal Tax Rate)
Earnings Before Interest After Taxes
- Plus: Depreciation & Amortisation
- Less: Capital Expenditures
- Less: Increase/(Decrease) in Net Working Capital
- Total Revenue - (% Growth)
- Cost of Goods Sold - (% Margin)
- Selling, General and Administrative - (% Margin)
- Depreciation & Amortisation - (% Margin)
- Other Operating Expenses/(Income) - ($)
- Marginal Tax Rate - (%)
- Days
- Days Sales Outstanding (DSO)
- Days Inventory Held (DIH)
- Prepaid Expenses (% of Total Revenue)
- Other Current Assets (% of Total Revenue)
- Days Payable Outstanding (DPO)
- Deferred Revenue (% of Total Revenue)
- Accrued Liabilities (% of Total Revenue)
- Other Current Liabilities (% of Total Revenue)
- Excludes cas and short-term debt
- Increase in an asset is a USE of cash; a decrease is a SOURCE of cash.
- Increase in a liability is a SOURCE of cash and a decrease is a USE of cash.
- NWC increase is a USE of cash and a *DEDUCT from unlevered free cash flow.
- Discount rate to calculate PV a company's projected FCF and terminal value.
- Opportunity cost of capital - what an investor would expect to earn in an alternative investment with a similar risk profile.
- Weighted average of the company's cost of debt (tax-effected) and cost of equity based on an assumed or "target" capital structure.
- WACC = (After-tax Cost of Debt) * (% of Debt in the Capital Structure) + (Cost of Equity * % of Equity in the Capital Structure).
- WACC =
$(r_{d}\times (1-t))\times \frac{D}{D+E} + r_{e}\times\frac{E}{D+E}$ .
- Determine Target Capital Structure
- Estimate Cost of Debt (
$r_{d}$ ) - Estimate Cost of Equity (
$r_{e}$ ) - Calculate WACC
Represented by ratio of Debt and Equity to Total Capitalisation
- Total Capitalisation - Market Value of Equity + Debt (generally balance sheet - book value)
How to determine
-
Current and historical levels
-
Public comparables are good benchmark
-
Public companies - generally use existing if in the range;
-
Private companies - generally use comparable mean/median.
- Formula:
$r_{d}\times(1-t)$ , where$t$ = marginal tax rate. Reflects company's credit profile at the target capital strucutre; key factors: - Size
- Sector
- Outlook
- Cyclicality
- Credit ratings/credit statistics
- Cash flow generation
- Reflects rate of return equity investor expects to earn
- More judgment involved - not readily observable
- Use the Capital Asset Pricing Model (CAPM)
$$(\text{Cost of Equity}) r_{e} = \text{Risk-Free Rate} + \text{Levered Beta}\times\text{Market Rist Premium}.$$ $$(\text{Cost of Equity}) r_{e} = r_{f}+\beta_{L}\times(r_{m}-r_{f}) + \text{size premium},$$ where$r_{f} = \text{risk-free rate}, \beta_{L} = \text{levered beta}, r_{m} = \text{expected return on the market}, r_{m}-r_{f} = \text{market risk premium}.$
- Expected rate of return obtained by investing in a "riskless" security.
- Generally look at Treasury rates - 10 or 30 years.
- Measures how stock moves relative to the market (S&P 500)
-
$> 1$ , stock moves more than $1 for every $1 that market moves -
$< 1$ , stock moves less than $1 for every $1 that market moves
Bloomberg reports levered data. To arrive at beta for private company,
-
Determine comparables group (same as comparable companies)
-
Unlever beta for each comparable company
$$\beta_{U} = \frac{\beta_{L}}{1+\frac{D}{E}\times(1-t)},$$ where$\beta_{U} = \text{unlevered data}, \beta_{L} = \text{levered data}, D/E = \text{debt-to-equity ratio}, t = \text{marginal tax rate}.$ -
Average unlevered data for the comparable group, Re-lever using company's target capital structure.
$$\beta_{L} = \beta_{U}\times\left(1+\frac{D}{E}\times(1-t)\right),$$ where$D/E = \text{target debt-to-equity ratio}.$
- Represents the spread of the expected market return over the risk-free rate.
- Concept - Smaller-sized companies are risker and should have a higher cost of equity.
- Add a size premium to the CAPM formula for smaller companies to account for thte preceived higher risk.
- DCF represents PV of all future FCF produced by a company
- Infeasible to project a company's FCF indefinitely
- So use Terminal value to capture the value of the company beyond the projection period.
- Typically calculated on the basis of the company's FCF in the final year of the projection period
- Terminal value typically accounts for a substantial portion of a company's value in a DCF.
- Two widely accepted methods: Exit Multiple Method (EMM) and Perpetuity Growth Method (PGM).
- Calculate terminal value as a multiple of its terminal year EBITDA.
- Multiple is typically based on the current LTM trading multiples for comparable companies.
- Needs to be subjected to sensitivity analysis
- Calculates terminal value by treating a company's terminal year FCF as a perpetuity growing at an assumed rate.
- Relies on the WACC calculation ("r") and an assumption regarding the company's long-term, sustainable growth rate ("perpetuity growht rate" or "g").
- Tends to be within a range of 2% to 4% (i.e. nominal GDP growth)
$$\text{Terminal Value} = \frac{FCF_{n}\times(1+g)}{r-g}.$$
- Follow concept of the time value of money : Dollar today is worth more than a dollar tomorrow.
- Discount each year's cash flows and terminal value using the WACC as the discount rate.
- Use WACC to calculate a discount factor for each period:
$$\text{Discount Factor} = \frac{1}{(1+\text{WACC})^{n}},$$ while$$\text{Present Value Calculation Using a Year-End Discount Factor} = \text{FCF}_{n}\times\text{Discount Factor} _{n}.$$
- Multiply each year's FCF and terminal value by appropriate discount factor
- Midyear convention - presumes cash flows occur ratably throughout the year:
$$\text{Enterprise Value} = \frac{\text{FCF}1}{(1+\text{WACC})^{0.5}} + \frac{\text{FCF}2}{(1+\text{WACC})^{1.5}} + ... + \frac{\text{FCF}5}{(1+\text{WACC})^{4.5}} + \frac{\text{EBITDA5}\times\text{Exit Multiple}}{(1+\text{WACC})^{5}}.$$
- DCF using UFCF arrives at an Enterprise Value.
- Calculate Equity Value by deducting net debt, preferred stock, noncontrolloing interest
- Divide by fully diluted shares to arrive at per share price.
DCF outcome significantly affected by certain key assumptions:
- WACC
- Exit multiple
- Perpetuity growth rate
- Common to perform sensitivity analyses to develop a valuation range
Pros:
- Cash flow based
- Market independent
- Self-sufficient
- Flexible
Cons:
- Dependence on multiple years of projections
- Highly sensitive to assumptions
- Terminal value is significant component
- Constant capital structure