VALUATION: A

CONCEPTUAL OVERVIEW
of Investment Banking Technical Training

In this chapter we will introduce the reader to some key, high-level concepts required to
understand valuation and how it’s done on Wall Street. We will cover three key topics:

 Enterprise Value: The 30,000-Foot View

 Understanding Enterprise Value vs. Market Value
 An Introduction to Valuation Techniques

Enterprise Value: The 30,000-Foot View

Investment bankers use four primary valuation techniques when advising corporate
clients. These techniques apply almost universally, regardless of the company, industry
or circumstance. They will be introduced in the next chapter, Valuation Techniques
Overview.

But how are the valuation techniques actually constructed? When should which
technique be used? What are the basic building blocks required for them? We will find
more detailed answers to some of these questions in the next chapter. However first
we’re going to take a step back and explain some of the building blocks of these
valuation techniques so that they make sense when we later discuss them in technical
depth.

In this chapter, therefore, you will find a detailed overview of the core building blocks of
the valuation techniques used by investment bankers.

Enterprise Value (frequently referred to as EV—not to be confused with Equity

Value, which is another name for Market Value of a company) is the core building
block used in financial modeling. The reason is this: Enterprise Value is designed to
represent the entire value of the company’s operations. By contrast, Market Value is a
residual: it represents the value of the company remaining once the value ascribed to
other stakeholders (non-owners) has been taken out.

Enterprise Value must therefore account for all of the differences between Market Value
(remember, this figure is the Market Value of a company’s Equity or ownership) and the
Value of Operations (or Operating Value) of a Company.
Let’s start with a basic identity equation:

Enterprise Value =
Operating Value of a Company =
Net Value of all the Claims on the Company’s Assets (Excluding Excess
Cash)

This equation is simple enough. Assuming that the company is profitable, and that it’s
more valuable in operation than in liquidation (in other words, the company is worth
more money if it continues in business rather than stopping business and selling off the
assets to the highest bidders), the value of the company is equal to the value of its
productive operations. This value must also equal the value of all of the net claims
against the company’s assets, because these assets are being used to produce money for
these claimants, or stakeholders (assuming, of course, that these claims have been
valued correctly). The “Excluding Excess Cash” piece will be explained in a moment.

The net value of all the claims on a company’s assets can be broken down as follows:

 Debt: Money that has been lent to the company by another person or institution.
Debt holders have a higher priority than equity holders on the claims of the
company’s assets and value, so they get paid first. In order to get to EV, we must add
Debt to the Market Value of the company’s Equity.
 Cash: Money that is owned by the company—in other words, it’s sitting on the
company’s balance sheet. This money, assuming it is not required by the operations
of the business, could be used to pay off existing claimants, or stakeholders. (For
example, the cash could be used to pay off Debt; it could also be used to repurchase
outstanding shares in the company’s Equity.) Thus the higher the Cash balance a
company has, the less its operations must be worth. This concept is counterintuitive:
shouldn’t owning more cash be a good thing? Yes, in a sense it is—but assume for a
moment that a company’s Market Value (of Equity) is fixed at a certain dollar
amount. That value can be ascribed to only two sources: (1) the residual claim value
on a company’s operations after all other stakeholders have been paid off, and (2) the
value of the money on the company’s balance sheet. The higher (2) is, the lower (1) is,
and vice versa. Therefore, to get to EV, we must subtract Cash from the Market
Value of the company’s Equity. (This is one way of looking at it. In practice, Cash is
often subtracted from Debt to get an important statistic called Net Debt. Net Debt is
the value of the Debt once balance sheet Cash has, hypothetically, been used to pay
some of it off. Diagrams below will explain the different ways of conceptualizing this.)
 Minority Interest: This is a tricky one. Corporations often have a Liability
account called Minority Interest (MI). This is a special accounting designation for a
specific scenario: when a Corporation owns most,   but not all, of a subsidiary
company. If that is the case, the subsidiary company is consolidated entirely into the
Corporation’s financial statements, so that it would appear, at first glance, that the
Corporation does indeed own 100% of that subsidiary. In fact it does not, so this
Liability account is created to represent the value of the shares owned in the
 subsidiary by other individuals or companies. (Similarly, there will be a
corresponding Minority Interest expense on the Income Statement for the
Corporation, representing the portion of value from the subsidiary’s operating results
that actually belongs to the other shareholders in the subsidiary.) Since this MI
represents the value of the partial ownership (by others) in this subsidiary, it should
be treated like Debt – that is, in order to get to EV, we must add Minority Interest to
the Market Value of the company’s Equity. (We should keep in mind, then, that this
EV statistic will include the entire value of the company’s subsidiary, even though
the Corporation itself does not own 100% of it.)
 Preferred Equity: Despite the name, Preferred Equity primarily operates as
Debt, not Equity. It is junior to all other forms of Debt, but it is also senior to the
Equity (often called Common Equity or just “common.”) Often, Preferred Equity
can be converted to shares of Common Equity, hence the name. It may be convertible
to Common Equity but, until that time, it receives interest and is in line ahead of the
Common Equity in the capital structure, so it is “preferred” to the common shares. It
receives preferential treatment. Because Preferred Equity is actually primarily Debt
unless and until it is converted to Equity, we must add Preferred Equity to the
Market Value of the company’s (Common) Equity.

Visually, we can look at this two different ways:

1. ENTERPRISE VALUE + CASH = TOTAL VALUE OF ALL

CLAIMS

2. ENTERPRISE VALUE = NET VALUE OF ALL CLAIMS

Typically, investment bankers and investors look at this equation the second way (the
Net Debt/Net Value version). This is the one to be most familiar with.

ANOTHER VIEW OF ENTERPRISE VALUE

There is another way of looking at EV: core assets vs. non-core assets. Core assets are
used to generate profit for the business; non-core assets are things owned by the
business but not central to its money-generating operations.

 Core Assets: assets critical to the operating business, such as Inventory, Fixed

Assets, Accounts Receivable, etc.
 Non-Core Assets: assets not critical to the operating business such as
Derivatives, Currencies, Real Estate, Commodities, Stock Options, etc.

In this sense, Cash on the Balance Sheet usually (at least for the most part) is non-core.
Unless it’s cash that the business needs to operate (such as dollar bills in the registers at
a retail operations), it is not being used to generate profit in the business operations.
That’s why it is stripped out in EV calculations. (Other non-core assets may be as well,
especially if they can be sold off for cash without harming the operations of the business.
For example, Real Estate and Commodities can often be sold without impacting the
Company’s cash-generating operations.)

Therefore Cash is (generally) a non-core asset. Other similar assets, such as Marketable
Securities, are simply ways of attempting to earn profit on that Cash, but are not core to
the company’s operations. These Cash-like assets can also be sold off, and should be
stripped out of the Net Debt Calculation.

PRIMARY COMPONENTS OF NET DEBT

 (+) Short-Term Debt: Debt with less than one year maturity.

 (+) Long-Term Debt: Debt with more than one year maturity.
 (+) Debt Equivalents: Operating Leases and Pension Shortfalls.
 (–) Cash and Cash Equivalents: Cash, Money Market Securities, and
Investment Securities

Notice in this list that “Cash and Cash Equivalents” is a subtraction from the calculation
—Cash and Cash-like assets are thus a sort of “anti-Debt.” Debt can also come in several
different flavors, but on the Balance Sheet it’s almost always broken down into Short-
Term Debt and Long-Term Debt. This is because Short-Term Debt is coming due soon
(within less than a year), and thus must be paid off or refinanced in the near future. This
may be of interest if the company is having financial trouble—the due date on the near-
term Debt may trigger difficulties for the Company in terms of repayment. This type of
difficulty, which can end up being a crisis under the right circumstances, is called
a liquidity problem (or crisis).

Understanding Enterprise Value vs. Market Value

Nearly all valuation techniques will focus on either Enterprise Value or Market Value (or
Equity). So which do we use, and when? In a nutshell:

Techniques related to the value available to shareholders should focus on

Market Value (of Equity).
Similarly,
Techniques related to the value available to all stakeholders should focus
on Enterprise Value.

Let’s start by looking at three commonly used trading multiples:

 EV/Sales: Enterprise Value ÷ Sales (or Revenue)

 EV/EBITDA: Enterprise Value ÷ EBITDA (Earnings before Interest, Taxes,
Depreciation & Amortization)
 Price/Earnings (or P/E): Market Value of Equity ÷ Net Income (alternatively,
Stock Price ÷ Earnings Per Share, or EPS)

Notice that in the first two examples, Enterprise Value is used. This is because Sales and
EBITDA generate profit/value that is available to all stakeholders. No compensation has
yet been taken out for non-Equity stakeholders. By contrast, Price/Earnings reflects the
Net Income for a company, which is computed after compensation for other
stakeholders has been removed (Interest Expense and Minority Interest). Therefore,
this profit/value is only available to Equity stakeholders.

People new to valuation may ask, “Why is it incorrect to use Market Value/EBITDA or

Enterprise Value/Net Income?” The answer lies in the fact that for any multiple, the
denominator and numerator within that multiple must
either include or exclude leverage. In other words, both the numerator and denominator
must both relate to either all stakeholders or only shareholders. Otherwise,
comparisons across companies will not be “apples-to-apples”—they will be difficult to
compare because different companies utilize different amounts of leverage.

This concept is demonstrated in the following graphic:

In summary:

Enterprise Value matches with Revenue, EBITDA and EBIT—items

found before Interest Expense (and Minority Interest, where applicable) on
the Income Statement.
Conversely,
Market Value matches with Pre-Tax Income (sometimes called Earnings
Before Taxes, or EBT), Net Income, and Earnings Per Share—items
found after Interest Expense (and Minority Interest, where applicable) on
the Income Statement.

An Introduction to Valuation Techniques

You will read about the four main valuation techniques for Investment Bankers in great
detail in the upcoming chapters. Here is a brief overview of them all, with this concept of
Enterprise Value vs. Market Value in mind:
COMPARABLE COMPANY ANALYSIS

 Comparable Company Analysis, frequently referred to simply as “Comps,” is a

valuation technique used to find company values based on traded values of similar
(comparable) companies.
 Comps a market-based valuation analysis relying on current market prices for
publicly traded companies.
 Comps valuation can revolve around either the Enterprise Value of the
company or the Market Value of the company, depending on the multiples being
used. For example, EV/Sales or EV/EBITDA multiples would refer to Enterprise
Value, while Price/Earnings multiples (equivalent to Market Value/Net Income)
would refer to Market Value.

THE THREE MAIN STEPS OF A COMPS VALUATION

1. Identify publicly-traded companies with characteristics similar to those of the

company being valued.
2. “Spread” the Comps—i.e., map-out the trading multiples (EV/Sales, EV/EBITDA,
and P/E) for this set of comparable companies.
3. Assign these multiples to company financial results to determine valuation
ranges.

COMPARABLE COMPANIES ANALYSIS EXAMPLE

 ABC Company is currently generating annual Net Income of $150 million.

 Publicly traded comparable companies are trading, on average, at 10x current
year Net Income.
 How much is the Equity of this company worth?

Using Comparable Company Analysis, this company’s Equity is worth $1.5 billion based

on $150 million of Net Income and the comparable company average of 10x Net Income.
Note that a proper range of the valuation can be obtained by looking at the highest and
lowest Net Income multiples in the comparable companies set.
DISCOUNTED CASH FLOW (DCF) ANALYSIS

 DCF analysis values a company by projecting its future Free Cash Flows (FCF)

and then using the Net Present Value (NPV) method to value the firm.
 DCF valuation builds off of Free Cash Flow forecasts that are typically done for
the upcoming 5 to 10 years.
 DCF valuation primarily returns the Enterprise Value of the company, because
Free Cash Flow refers to the cash generated by the operations of a business,
irrespective of Net Debt and Minority Interest/Preferred Equity. However a DCF
model can also be used to project Market Value if Interest Expense and Minority
Interest are projected and stripped out to produce Levered Free Cash
Flows (LFCF).

THE FOUR MAIN STEPS OF A DCF VALUATION

1. Forecast out a company’s Free Cash Flows for the next 5-10 years.
2. Calculate the Weighted Average Cost of Capital (WACC).
3. Calculate the firm’s Terminal Value, or the future value of the firm assuming a
stable long-term growth rate.
4. Discount 5-year Free Cash Flows plus Terminal Value back to Year 0 (today) to
derive the Enterprise Value of the company.

Free Cash Flows are discounted back to Year 0 (today) to solve for Enterprise Value, as
displayed in this graphic:
PRECEDENT TRANSACTION ANALYSIS

 Precedent Transaction Analysis, also called “Comparable Transactions,” looks at

recent historical M&A activity involving similar companies to get a range of valuation
multiples.
 This transaction valuation analysis relies on whatever historical M&A transaction
information is available.
 Precedent Transaction valuation can revolve around either the Enterprise
Value of the company or the Market Value of the company, depending on the
multiples being used. For example, EV/Sales or EV/EBITDA multiples would refer to
Enterprise Value, while Price/Earnings multiples (equivalent to Market Value/Net
Income) would refer to Market Value. The most commonly used transaction
multiples are EV/Sales, EV/EBITDA, and P/E.

THE THREE MAIN STEPS OF PRECEDENT VALUATION

1. Identify publicly traded companies with similar characteristics.

2. “Spread” the comps or map-out trading multiples such as EV/Sales, EV/EBITDA,
and P/E.
3. Assign industry multiples to company figures to determine valuation ranges.

PRECEDENT TRANSACTION ANALYSIS EXAMPLE

 PDQ Company is currently generating annual Net Income of $150 million.

 Precedent M&A transactions since 2004 have shown industry average of 20x P/E
(see image below).
 How much is the Equity of this company worth?

Using Precedent Transaction Analysis, PDQ’s Equity is worth $3.0 billion based on $150

million of Net Income and the precedent P/E multiple of 20x Net Income. Note that a
proper range of the valuation can be obtained by looking at the highest and lowest Net
Income multiples in the precedent transactions set.
LEVERAGED BUYOUT (LBO) ANALYSIS

 An LBO is the acquisition of a public or private company with a significant

amount of borrowed funds. Leveraged Buyout Analysis is discussed later in this
training module; it is also discussed in great depth in the Private Equity Training
Module.
 LBO acquirers are typically Private Equity sponsors.
 This is a transaction-based valuation technique. Private Equity buyers typically
look to sell the business within 5 years after purchase.
 LBO valuation revolves around the Enterprise Value of the company, because
the entire business will be acquired and all (or essentially all) of the pre-existing Debt
will be paid off.

THE FIVE MAIN STEPS IN AN LBO ANALYSIS

1. Make transaction assumptions based on the purchase price, Debt interest rate,
etc.
2. Build the Sources & Uses table, where “Sources” lists how the transaction will
be financed and “Uses” lists the capital uses—i.e., where the “Sources” money will be
spent.
3. Adjust the Balance Sheet for the new Debt and Equity, and other transaction-
related adjustments.
4. Project out the three financial statements (usually 5 years) and determine how
much Debt is paid down each year.
5. Calculate exit value scenarios based on EBITDA multiples.
 VALUATION TECHNIQUES
OVERVIEW
of Investment Banking Technical Training

Investment banks perform two basic, critical functions for the global marketplace. First,
investment banks act as intermediaries between those entities that demand capital (e.g.
corporations) and those that supply it (e.g. investors).  This is mainly facilitated through
debt and equity offerings by companies.  Second, investment banks advise corporations
on mergers & acquisitions (M&A), restructurings, and other major corporate actions.
The majority of investment banks perform these two functions, although there are
boutique investment banks that specialize in only one of the two areas (usually advisory
services for corporate actions like M&A).

In providing these services, an investment bank must determine the value of a company.
How does an investment bank determine what a company is worth? In this guide you
will find a detailed overview of the valuation techniques used by investment bankers to
facilitate these services that they provide.

In this chapter we will cover two primary topic areas:

 How do bankers determine how much a company is worth—in other words, what
valuation techniques are typically used?
 What are the advantages and disadvantages of each valuation technique,
and when should which technique be used?

Valuation Techniques: Overview

While there are many different possible techniques to arrive at the value of a company—
a lot of which are company, industry, or situation-specific—there is a relatively small
subset of generally accepted valuation techniques that come into play quite frequently,
in many different scenarios. We will describe these methods in greater detail later in this
training course:

 Comparable Company Analysis (Public Comps): Evaluating other, similar

companies’ current valuation metrics, determined by market prices, and applying them to the
company being valued.
 Discounted Cash Flow Analysis (DCF): Valuing a company by projecting its future
cash flows and then using the Net Present Value (NPV) method to value the firm.
 Precedent Transaction Analysis (M&A Comps): Looking at historical prices for
completed M&A transactions involving similar companies to get a range of valuation multiples.
This analysis attempts to arrive at a “control premium” paid by an acquirer to have control of the
business.
 Leverage Buyout/“Ability to Pay” Analysis (LBO): Valuing a company by
assuming the acquisition of the company via a leveraged  buyout, which uses a significant
amount of borrowed funds to fund the purchase, and assuming a required rate of return for the
purchasing entity.

These valuation techniques are easily the most commonly used, other than in valuations
for specific, niche industries such as oil & gas or metal mining (and even in those
industries, the aforementioned valuation techniques frequently come into play).
Different parts of the investment bank will use these core techniques for different needs
in different circumstances. Frequently, however, more than one technique will be used
in a given situation to provide different valuation estimates, with the concept being to
triangulate a company’s value by looking at it from multiple angels.

For example, M&A bankers are typically most interested in Transaction and
Comparables valuation for acquisition and divestiture. Equity Capital Markets (ECM)
bankers underwrite company shares in the public equity markets in advance of an initial
public offering (IPO) or secondary offering, and thus rely heavily on Comparables
valuation. Financial sponsors and leveraged finance groups will almost always value a
company based upon leveraged buyout (LBO) transaction assumptions, but will also
look at others. Also, in many cases, all of these groups will employ some degree of DCF
valuation analysis. These different divisions of an investment bank may come up with
similar valuation ranges using some subset of the techniques given, but will approach
this process often with entirely different goals in mind.
Thus all of these techniques are used routinely by investment banks, and for a banking
analyst, at least some degree of familiarity with all of these techniques must be achieved
in order for that analyst to be considered proficient at his or her job.

When To Use Each Valuation Technique

All of the valuation techniques listed earlier should be practiced by a junior banker, but
some may be more applicable than others, given the group, the client, and the exact
situation.

COMPARABLE COMPANY ANALYSIS

The Comparable Company valuation technique is generally the easiest to perform. It

requires that the comparable companies have publicly traded securities, so that the
value of the comparable companies can be estimated properly. We will detail the
calculation process for Comparable Company analysis later in this guide.

The analysis is best used when a minority (small, or non-controlling) stake in a company
is being acquired or a new issuance of equity is being considered (this also does not
cause a change in control). In these cases there is no control premium, i.e., there is no
value accrued by a change in control, wherein a new entity ends up owning all (or at
least the majority) of the voting interests in the business, which allows the owner to
control the company cleanly. With no change of control occurring, Comparable
Company analysis is usually the most relied-upon technique.

DISCOUNTED CASH FLOW ANALYSIS (DCF)

A DCF valuation attempts to get at the value of a company in the most direct manner
possible: a company’s worth is equal to the current value of the cash it will generate in
the future, and DCF is a framework for attempting to calculate exactly that. In this
respect, DCF is the most theoretically correct of all of the valuation methods because it
is the most precise.

However, this level of preciseness can be tricky. What DCFs gain in precision (giving an
exact estimate based on theory and computation), they often lose in accuracy (giving a
true indicator of the exact value of the company). DCFs are exceedingly difficult to get
right in practice, because they involve predicting future cash flows (and the value of
them, as determined by the discount rate), and all such predictions require
assumptions. The farther into the future we predict, the more difficult these projections
become. Any number of assumptions made in a DCF valuation can swing the value of
the company—sometimes quite significantly. Therefore, DCF valuations are typically
most useful and reliable in a company with highly stable and predictable cash flows,
such as an established Utility company.
Because DCFs are so difficult to “get perfect,” they are typically used to supplement
Comparable Companies Analysis and Precedent Transaction Analysis (discussed next).

PRECEDENT TRANSACTION ANALYSIS

The Precedent Transaction valuation technique is also generally fairly easy to perform.
It does require that the specifics of a prior acquisition/divestiture deal are known (price
per share, number of shares acquired or spun off, amount of debt assumed, etc.), but
this is usually the case if the target (acquired company) had publicly traded instruments
prior to the transaction. In some industries, however, relatively few truly comparable
M&A transactions have occurred (or the acquisitions were too small to have publicized
deal details), so the Precedent Transaction analysis maybe be difficult to conduct.

If the buyer acquires a majority stake in a company (or similarly, when a controlling
stake in a business is divested), a Precedent Transaction analysis is almost always the
theoretically correct Comparable Company analysis to perform. Why do we use
Precedent Transactions analysis in this scenario? Because when a majority stake is
purchased, the buyer assumes control of the acquired entity. By having control over the
business, the buyer has more flexibility and more options about how to create value for
the business, with less interference from other stakeholders. Therefore, when control is
transferred, a control premium is typically paid.

Precedent Transactions are designed to attempt to ascertain the difference between the
value of the comparable companies acquired in the past before the transaction
vs. after the transaction. (In other words, the analyst determines the difference between
the market value of the company before the transaction is announced vs. the amount
paid for the company in a control-transferring purchase.) This difference represents the
premium paid to acquire the controlling interest in the business. Thus when a change of
control is occurring, Precedent Transaction analysis should typically be one of the
valuation methods used.

We will detail the calculation process for Precedent Transaction analysis later in this
guide.

LEVERAGE BUYOUT ANALYSIS (LBO)

Another possible way to value a company is via LBO analysis. LBOs are typically used by
“financial sponsors” (private equity firms) who are looking to acquire companies
inexpensively in the hopes that they can be sold at a profit in several years. In order to
maximize returns from these investments, LBO firms generally try to use as much
borrowed capital (debt financing) as possible to fund the acquisition of the company,
thereby minimizing the amount of equity capital that the sponsor itself must invest
(equity financing). Assuming that the investment makes a profit, this debt leverage
maximizes the return achieved for the sponsors’ investors.
 There are three possible approaches to take in running an LBO analysis for a target
company:

1. Assume a minimum required return for the financial sponsor plus an appropriate
debt/equity ratio, and from this impute a company value.
2. Assume a minimum required return for the financial sponsor plus an appropriate
company value, and from this impute the required debt/equity ratio.
3. Assume an appropriate debt/equity ratio and company value, and from this compute the
investment’s expected return.

Usually the first analysis is performed by investment bankers. If the value of the
company is unknown (as is usually the case), then the goal of the LBO exercise is to
determine that value by assuming an expected return for a private equity investor
(typically 20-30%) and a feasible capital structure, and from that, determining how
much the company could be sold for (and thereby still allow the financial sponsor to
achieve that required return). If the expected sale price/value of the company is known
(for example, if a bid on the company has been proposed), then the primary goal of
performing an LBO analysis is to determine the best possible returns scenario given that
value. (Bankers will often use LBO analysis to determine whether a higher valuation
from private equity investors is possible, again using the first analysis.)

LBO analysis can be quite complex to perform, especially as the model gets more and
more detailed. For example, different assumptions about the capital structure can be
made, with increasing layers of refinement, to the point where each individual
component of the capital structure is being modeled over time with a host of tranche-
specific assumptions and features. That said, a simple, standard LBO model with
generic, high-level assumptions can be put together fairly easily.

Unfortunately, LBO valuations can be highly subject to market conditions. In a poor

market environment (periods of low capital markets activity, high interest rates, and/or
high credit spreads for High Yield bond issuances),  this type of transaction is difficult to
use. Hence LBO investing is highly cyclical depending upon market forces.

Check out our Private Equity Training Course for much more detail on conducting LBO
analysis.

Valuation Technique Advantages and Disadvantages

Each valuation method naturally has its own set of advantages and disadvantages. Some
are more reliable and accurate, while others are easier to perform, for example.
Additionally, some valuation methods are specifically indicated in certain
circumstances. Here are the main Pros and Cons of each method:

COMPARABLE COMPANY ANALYSIS

 Pro: Market efficiency ensures that trading values for comparable companies serve as a
reasonably good indicator of value for the company being evaluated, provided that the
comparables are chosen wisely. These comparables should reflect industry trends, business risk,
market growth, etc.
 Pro: Values obtained tend to be most reliable as an indicator of value of the company
whenever a non-controlling (minority) investment scenario is being considered.
 Con: No two companies are perfectly alike, and as such, their valuations generally should
not be identical either. Thus comparable valuation ratios are often an inexact match. Also, for
some companies, finding a decent sample of comparables (or any at all!) can be very
challenging. As a result in Comparable Companies analysis are always running the risk of
“comparing apples to oranges,” never being able to find a true comparable, or simply having an
insufficient set of comparable valuations from which to draw.
 Con: Illiquid comparable stocks that are thinly traded or have a relatively small
percentage of floated stock might have a price that does not reflect the fundamental value of that
company.

DISCOUNTED CASH FLOW (DCF) ANALYSIS

 Pro: Theoretically the most sound method if one is very confident in the projections and
assumptions, because DCF values the individual cash streams (the actual source of the
company’s value) directly.
 Pro: DCF method is not heavily influenced by temporary market conditions or non-
economic factors.
 Con: Valuation obtained is very sensitive to modeling assumptions—particularly growth
rate, profit margin, and discount rate assumptions—and as a result, different DCF analyses can
lead to wildly different valuations.
 Con: DCF requires the forecasting of future performance, which is very subjective, and
most of the value of the company is usually derived from the “terminal value,” which is the set of
cash flows that occurs after the detailed projection period (and is therefore usually projected in a
very simple way).

PRECEDENT TRANSACTION/PREMIUM PAID ANALYSIS

 Pro: Generally regarded as the best valuation tool for control-transferring transactions

because the previous transaction has validated the valuation (in other words, a precedent has
been established, whereby a previous buyer has actually paid the amount specified in the
precedent transaction).
 Pro: Assuming that the required transaction data is available/public information,
precedent transactions are typically an easy analysis to perform.
 Con: The valuation multiples found in prior transactions typically include control
premium and synergy assumptions, which are not public knowledge and are often transaction-
specific. These assumptions are not always achievable by other market participants conducting a
new transaction.
 Con: Precedent Transaction valuations are easily influenced by temporary market
conditions, which fluctuate over time. For example, a prior transaction might have been
conducted in a more favorable environment for debt or equity issuance.
 LEVERAGE BUYOUT (LBO) ANALYSIS

 Pro: An excellent means to establish a “floor” valuation—i.e., an LBO analysis will

determine the amount that a financial buyer (sponsor) would be willing to pay for the company,
thereby determining the value that a strategic bidder will have to exceed.
 Pro: LBO valuation is realistic, as it does not require synergies to achieve (financial
buyers usually do not have synergy opportunities).
 Con: Ignoring synergies could result in an underestimated valuation, particularly for a
well-fitting strategic buyer.
 Con: The valuation obtained is very sensitive to operating assumptions (growth rate,
operating working capital assumptions, profit margins, etc.) and financing cost assumptions
(and thus LBO valuation is dependent upon the quality of the prevailing financing market
conditions).

Valuation Building Blocks: Company Value

In order to use the valuation techniques described above, it is important to understand a
few core building blocks of valuation. These concepts will be used in much more detail
in later chapters of this training course, wherein we will walk you through how to
conduct these valuations in explicit detail.

There are three common, related terms used to describe the “value” of a company:

 Enterprise Value: Represents the total value of a company’s net operating assets. In

other words, “Enterprise Value” is the value of the entire company.
 Market Value: Also known as “Market Capitalization” or “Equity Value,” market value
represents the dollar value of a company’s issued shares of common equity. It is calculated by
multiplying shares outstanding by the current stock price.
 Book Value: The accounting valuation of the equity. Book Value simply equals Total
Assets – Total Liabilities. Book Value is often called “liquidation value,” because it represents
the expected value of a company’s assets after they are used to pay off all existing liabilities. This
generally assumes, of course, that the company will be ceasing operations.

WHAT IS THE DIFFERENCE BEEN BOOK VALUE AND

MARKET VALUE?

Market Value is almost always larger then Book Value for three primary reasons:

 Market Value includes future growth expectations while Book Value does not.
 Market Value includes brand value and company intangible assets.
 Market Value includes value accrued by the company historically through wise
managerial decision making, while Book Value generally does not.
 In other words, Book Value is a value arrived at for a company by simply following the
rules of standard accounting based on a company’s past transactions and operations,
while Market Value takes into account all information about a company’s operations,
including future expectations.

HOW DO YOU CALCULATE MARKET VALUE AND

ENTERPRISE VALUE?

Market Value is calculated based on the number of shares outstanding multiplied by the
company’s current stock price.

Enterprise Value represents the total value of the firm and is found by adding the Net
Debt of a company to Market Value, where Net Debt is simply the company’s Debt
outstanding minus excess Cash on the company’s balance sheet.

WHY IS CASH SUBTRACTED OUT?

Cash is subtracted out of Enterprise Value because excess Cash is considered a non-
operating asset. For example, that Cash often could be used to pay down part of the
company’s debt immediately, which reduces the Enterprise Value of the Company.
(Note that the definition of “excess cash” is somewhat loose, as it refers to cash that is
not needed to conduct the operations of the business; a simplifying assumption in most
cases is to count all Cash as excess Cash.)

WHEN SHOULD ENTERPRISE VALUE BE USED?

Enterprise Value should be used for ratios and other calculations that measure the total
return to all capital holders (such as Revenue, Earnings Before Taxes (EBT); Earnings
Before Interest and Tax (EBIT); Earnings Before Interest, Taxes, Depreciation and
Amortization (EBITDA); Net Operating Profit After Tax; Operating Cash Flow; etc.),
whereas Equity Value should be used for ratios that measure the total return
to shareholders (such as Earnings/Net Income).

Here are a couple of simple examples of how to calculate Enterprise Value based on
information available for a company:

SOLVING FOR ENTERPRISE VALUE, EXAMPLE 1:

 Cash:                   $200

 Debt:                   $400
 Equity:             $1,600
 Enterprise Value = Market Value of Equity ($1,600) + Debt ($400) – Cash ($200) =
$1,800.

SOLVING FOR ENTERPRISE VALUE, EXAMPLE 2:

 Shares Out.:       1,000

 Stock Price:           $10
 Debt:                $5,000
 Cash:                $1,000

Enterprise Value = Market Value of Equity (1,000 × $10 = $10,000) + Debt ($5,000) –
Cash ($1,000) = $14,000.