PE vs EV EBITDA
When we calculate the market value of equity of the comparable company, remember to get the fully diluted shares outstanding first.
P/E: how much an investor is willing to pay for a dollar of earnings/ how long it takes to get your
investment back.
You would only be valuing the equity because the metric is earnings, which hypothetically could be distributed to those that own the equity of the firm.
Pros:
1. Quick screening and important benchmark for investment.
2. Measures the growth potential.
3. Are used to value financial services companies like banks since they have little to no "capital structure" related debt and interest expense is an normal operating expense
Cons:
1. Can be negative
2. Tend to be manipulated
3. Net income will include extraordinary items, discontinued operations, effects from accounting changes...that will need to be excluded.
4. Depends on capital structure, depreciation.
EV/EBITDA:
If you use an EV/EBITDA multiple you would be calculating the total value of the firm, including the debt, since you are using a metric which excludes interest expense.
(EV/sales may be used to value an early stage technology company that is aggressively growing sales, but has yet to achieve profitability.)
Pros:
1. Accounts for the entire company and ignores capital structure. Measures the profitability of the core business and cash-generating power of the entire firm. So EV/EBITDA is used for pure valuation.
2. Ignores the distorting effects of individual countries' taxation policies, different accounting methods for depreciation
Less than 20% Cost method, only take in the dividends received
20%-50% Equity method, take in the proportional earnings (net income from minority interest) Greater than 50% Consolidation method (Why add it back in the EV)
If a company owns greater than 50% of a subsidiary, it is required by GAAP to consolidate its financial statements, including the portion of earnings to which they are NOT actually entitled on the I/S, and the value of the equity they do NOT own on the B/S, which are each referred to as Minority Interest or Non-Controlling Interest
In order to calculate EV, we add back Minority Interest from the B/S so that any ratios (because EBITDA includes that comes from what you don’t own) are apples to apples; it would also work to subtract the earnings associated with the subsidiary, but that information is rarely disclosed
P/B:
Apply to companies capital intensive with large amount of tangible assets. Not applied to those with huge intangible assets like brand name or patent.
Especially suitable to banks as the market value of equity close to book value of equity.
Cons:
1. Value of certain intangible assets hard to estimate
2. Different accounting method results in difference in book value
3. Account for book value of assets but not market value
Precedent Transaction
It is not uncommon to consider transactions involving companies in different, but related, sectors that may share similar end markets, distribution channels, or financial profiles. As a general rule, the most recent transactions are the most relevant as they likely took place under similar market conditions to the contemplated transaction. In some cases, however, older transactions may be appropriate to evaluate if they occurred during a similar point in the target’s business cycle or macroeconomic environment.
Pros:
1. Similar size, industry & business, market situation.
?market-based
?relativity
?simplicity
?objectivity
Cons:
1. Higher valuation because of control premium and synergies.
?time lag
?existence of comparable acquisitions
?availability of information (business confidentiality)acquirers sometimes safeguard these details and only disclose information that is required by law or
regulation.
Comparable Companies
Customers: Companies with a similar customer base tend to share similar opportunities and risks. End markets: companies that sell products and services into the same end markets generally share a similar performance outlook.
A company’s end markets refer to the broad underlying markets into which it sells its products and services. For example, a plastics manufacturer may sell into several end markets, including automotive, construction, consumer products, medical devices, and packaging.
Distribution channel: Wholesale/retail.
Geography: local demographics, economic drivers, regulatory regimes, consumer buying patterns and preferences, and cultural norms
For a target with no clear, publicly traded comparables, the banker seeks companies outside the target’s core sector that share business and financial characteristics on some fundamental level. For example, a medium-sized manufacturer of residential windows may have limited or no truly direct publicly traded peers in terms of products, namely companies that produce windows. If the universe is expanded to include companies that manufacture building products, serve homebuilders, or have exposure to the housing cycle, however, the probability of locating companies with similar business drivers is increased. In this case, the list of potential comparables could be expanded to include manufacturers of related building products such as decking, roofing, siding, doors, and cabinets Pros:
?market-based: based on actual market data; reflect market growth, risk and sentiment
?relativity: easily measurable and comparable to other companies
?quick and convenient
?current: can be updated on a daily basis
Cons:
?absence of relevant comparables, no pure-play
?company-specific issues
?market situation changes
?not accurate if the entire industry is over/undervalued
?disconnect from the intrinsic value estimated from cash flows
DCF (P.140)
Sales Projection
Historical trend; comparable company at a similar stage
Depreciation Projection
1. As a percentage of sales or capex based on historical levels as it is directly related to a company’s capital spending, which, in turn, tends to support top line growth.
2. Build a detailed PP&E schedule9 based on the company’s existing depreciable net PP&E base and
incremental capex projections.
Capital Expenditure Projection
capex is generally driven as a percentage of sales in line with historical levels due to the fact that top line growth typically needs to be supported by growth in the company’s asset base.
Net Working Capital Projection
1. As a percentage of Sales/ constant NWC turnover ratio
2. project the individual components of both current assets and current liabilities for each year in the projection period. (Ratios that can be used:
Days sales outstanding = Accounts receivable / sales * 365
Days inventory held = Inventory / COGS * 365
Inventory turnovers = COGS / inventory
Days payable outstanding = Accounts payable / COGS * 365)
WACC
WACC is predicated on choosing a target capital structure for the company that is consistent with its long-term strategy. Target capital structure: management decision or proxy firms
CAPM
Risk free rate: 10-year T-bond. (compromise)
- 30 yrs consists inflation premium
- 1 yr is too short for typical investment horizon in a company
Market Risk Premium: The equity risk premium employed on Wall Street typically 4% to 8%. Terminal value
There are two widely accepted methods used to calculate a company’s terminal value—the exit multiple method (EMM) and the perpetuity growth method (PGM). The EMM calculates the remaining value of the target after the projection period on the basis of a multiple of the target’s terminal year EBITDA (or EBIT). The PGM calculates terminal value by treating the target’s terminal year FCF as a perpetuity growing at an assumed rate. Use one to calculate the implied other, check.
Pros:
1. Cash flow based, a mor e fundamental approach to valuation than using multiples-based methodologies. Intrinsic value
2. Independent of the ups and downs in the market
3. Allow us to run different scenario under different assumptions
4. Identifies where companies value is coming from and if current stock price is justified (you can plug the company's current stock price into the DCF model and, working backwards, calculate how quickly the company would have to grow its cash flows to achieve the stock price.)
Cons:
1. Many assumptions and depend on financial projections
2. Tend to be over optimistic
3. Terminal Value calculation projects the FCF into the future at the same rate, which will clearly never happen. Change in growth of terminal value is sensitive and it takes a large part in the valuation.
4. The debt to equity ratio is held constant in the WACC, not so realistic
5. Not for short-term investment. A well-crafted DCF may help you avoid buying into a bubble, but it may also make you miss short-term share price run-ups that can be profitable. Moreover, focusing too much on the DCF may cause you to overlook unusual opportunities.