How to Value Companies and Its’ Applications in DCM

[RomWharf1]

The two main methodologies used for the valuation of a company are:

• DCF (Discounted Cash Flows)
• EBITDA multiples

DCF methodology:

Compared with the EBITDA multiple methodology explained later in this post, the DCF will be more precise, and specific to one specific business. The DCF will look to bring forward all the future cash flows to the date of the investment by discounting these future cash flows. The formula is:

View attachment 151

Where:

EV = Enterprise Value

CF= Cash flow at period n

TV = Terminal Value

r = Discount rate (WACC)

T = number of years chosen to discount the cash flows

To be able to use this approach, one would need to be able to access detailed P&L and cash flows, both historical and forecast. It is also important to distinguish two different values: the Enterprise Value (EV) and the Equity Value. The Enterprise Value represents the value of the company itself, without taking into consideration its capital structure. To get the EV, cash flows used are cash flows prior to any debt servicing which are not linked to operations. These are called Free Cash Flow to the Firm (FCFF).

The Equity Value is the value of the company to shareholders (i.e., after any debt considerations). To get the Equity Value, the cash flow used are Free Cash Flow to Equity (FCFFE). FCFFE are FCFF, to which any interest-bearing debt cash flows have been deducted. These additional main deductions include debt drawdown, debt repayment or interest payments. This should more or less represent the final “cash available” line.

It is also important to select a representative number of years for the discounted cash flow - in the formula, this is “T”. For example, a start-up will only rely on its projections to be able to extract a value for its company. These cash flow should be lower in early years and ramp up to a more stable level in later year. A longer period of time will then be necessary to use the DCF approach with that type of company. More mature company will however have more stable cash flows - a shorter period of time can be sufficient to use the DCF methodology. Similarly, if a mature company decides to implement a specific growth project, cash flows will also vary, and longer period of times may be required. Generally, investor will look at the first five to ten years to get a representative sample for the valuation. Indeed, discounted cash flows in year fifteen, for example, will not change the final value of the company significantly given the discount factor applied will be quite high, reducing the impact of later years cash flows.

Some exceptions could be made, for example for fixed term projects. A mine may have a limited life of 20 years, after which time no more cash flows will be extracted from the project. In this instance, a DCF over the life of the mine should be considered.

The Terminal Value (TV) represents the period after the last cash flow used for the DCF. For example, if 5 years of cash flows are used for the valuation, the Terminal Value will represent the value of the company from year 5 onwards. This could be:

• Perpetual growth value: Constant growth of cash flows at a specific rate
• Exit multiple (EBITDA multiple) – more common for equity investors looking to exit their investment in a few years’ time

The TV is useful given it is difficult to assess precisely what a company will look like beyond 5-10 years. The Terminal Value formula is:

View attachment 152

Where:

CF(T) = Cash flow of the last period considered for the DCF

g = perpetual growth rate of the company beyond T

r = Discount rate (WACC) used for the DCF

EBITDA multiple methodology:

There are two main EBITDA multiple approaches:

• Peers comparison
• Precedent transactions

Peers comparison looks at public companies’ market value and deduce the Enterprise Value by adding the net debt to it. The EBITDA available will allow a comparison of the EV / EBITDA multiple of the public company and apply that same multiple to the companies being studied to deduce the Enterprise Value.

Precedent transactions are similar in principle, but somewhat more complicated. This method will look at recent M&A transaction that happened and look at the multiple applied for the transaction. Generally, less information will be available, making it more difficult to have the relevant data for comparison.

Application in debt financing

Once the value of the company has been calculated, either using the DCF or the EBITDA multiple - or often an average of both, a debt investor will be able to understand the LTV it will apply on the company. To give a concrete example, this is very similar to a mortgage: If you want to purchase a house that has been valued at 100 with 80 of mortgage, the LTV is 80%. Mortgage lenders also look at your salary and will for example lend up to 5x your salary. This is similar for debt financing: if the company has been valued at 100, a debt investor might be reluctant to have more than 80 of debt on the company and will not want to lend more than 5x the EBITDA of the company. However, this means that a lender will want to understand how much debt is “in front” of him – i.e., how much debt is senior to what the investor will lend to the company. This is important for them as, should a company default on its debt and start a liquidation process, debt investors will be repaid according to their seniority. The more debt is in front of them, the more risk of loss they will have.

Finally, another important cash flow element for bond investors is :

View attachment 153

This shows how many times a company can cover its interest expenses with its earnings. Lenders generally look to have at least 1.5-2x interest coverage ratio in case the business plan is lower than budgeted.

 

[AugustusSeptimius1]

This is a really comprehensive post. Definitely clarified some of my understanding and will refer back to it when trying to double down on my comprehension of valuation technicals. Appreciate it!

 

[magellan1]

I agree with ARussell, this is a concise summary of company valuations. However, as they say, the devil is in the details.
Firstly, the DCF is not necessarily a more precise valuation methodology. The final valuation heavily depends on the quality of the inputs and assumptions. For example, if one makes a small mistake in calculating Cash Flows or under/overestimates the risk-free rate the result derived using this methodology can be very far from reality.
Secondly, EBITDA multiples are commonly used for the valuation of companies in industries like Utilities. It is highly unlikely for investors and business owners to value a young technology company based on its EBITDA. Price/Sales is a more popular valuation multiple for tech firms. There are several other valuation multiples (P/B, P/CF, etc) that can be used depending on the type of company and the industry.
Finally, it is important to take into consideration the market environment and the specific case. Let's say that you want to acquire a private company and you end up with a valuation of $20 million based on your DCF. The owner can tell you that he simply doesn't care about your valuation, he wants to receive $35 million and he already received multiple offers above your valuation.

 

[Chrisgilbert1111]

To value a private business in the discounted cash flow method, a VC/ PE firm must be serious about the acquisition, the target will likely disclose their books, but they still require to be audited to ensure accuracy. This is less commonly used as the primary barometer for private valuations due to the uncertainty of private companies’ financial statements.

Private companies’ accounting statements may also include personal expenses along with business expenses in the case of smaller family-owned businesses and have unexplained gaps across the board. However, if the acquiring firm is able to determine accurate numbers for revenue and operating costs, taxes, and working capital historically, they an model these numbers out to a 5–10-year timeframe (depending on the length of the project) and then determine Free Cash Flow.

Since the Free Cash Flow is representative of how much money the business has available to give back to shareholders, it is considered an accurate measure of a company’s fair value. The discount rate problem mentioned above also factors into calculating the company’s beta, which is the level of volatility associated with investing in the firm as opposed to the global equities market (typically, benchmark indices such as the S&P 500 are used for comparison).

Read more about Private equity valuation method

 

[zhulik881]

The two main methodologies used for the valuation of a company are:

• DCF (Discounted Cash Flows)
• EBITDA multiples

DCF methodology:

Compared with the EBITDA multiple methodology explained later in this post, the DCF will be more precise, and specific to one specific business. The DCF will look to bring forward all the future cash flows to the date of the investment by discounting these future cash flows. The formula is:

View attachment 151

Where:

EV = Enterprise Value

CF= Cash flow at period n

TV = Terminal Value

r = Discount rate (WACC)

T = number of years chosen to discount the cash flows

To be able to use this approach, one would need to be able to access detailed P&L and cash flows, both historical and forecast. It is also important to distinguish two different values: the Enterprise Value (EV) and the Equity Value. The Enterprise Value represents the value of the company itself, without taking into consideration its capital structure. To get the EV, cash flows used are cash flows prior to any debt servicing which are not linked to operations. These are called Free Cash Flow to the Firm (FCFF).

The Equity Value is the value of the company to shareholders (i.e., after any debt considerations). To get the Equity Value, the cash flow used are Free Cash Flow to Equity (FCFFE). FCFFE are FCFF, to which any interest-bearing debt cash flows have been deducted. These additional main deductions include debt drawdown, debt repayment or interest payments. This should more or less represent the final “cash available” line.

It is also important to select a representative number of years for the discounted cash flow - in the formula, this is “T”. For example, a start-up will only rely on its projections to be able to extract a value for its company. These cash flow should be lower in early years and ramp up to a more stable level in later year. A longer period of time will then be necessary to use the DCF approach with that type of company. More mature company will however have more stable cash flows - a shorter period of time can be sufficient to use the DCF methodology. Similarly, if a mature company decides to implement a specific growth project, cash flows will also vary, and longer period of times may be required. Generally, investor will look at the first five to ten years to get a representative sample for the valuation. Indeed, discounted cash flows in year fifteen, for example, will not change the final value of the company significantly given the discount factor applied will be quite high, reducing the impact of later years cash flows.

Some exceptions could be made, for example for fixed term projects. A mine may have a limited life of 20 years, after which time no more cash flows will be extracted from the project. In this instance, a DCF over the life of the mine should be considered.

The Terminal Value (TV) represents the period after the last cash flow used for the DCF. For example, if 5 years of cash flows are used for the valuation, the Terminal Value will represent the value of the company from year 5 onwards. This could be:

• Perpetual growth value: Constant growth of cash flows at a specific rate
• Exit multiple (EBITDA multiple) – more common for equity investors looking to exit their investment in a few years’ time

The TV is useful given it is difficult to assess precisely what a company will look like beyond 5-10 years. The Terminal Value formula is:

View attachment 152

Where:

CF(T) = Cash flow of the last period considered for the DCF

g = perpetual growth rate of the company beyond T

r = Discount rate (WACC) used for the DCF

EBITDA multiple methodology:

There are two main EBITDA multiple approaches:

• Peers comparison
• Precedent transactions

Peers comparison looks at public companies’ market value and deduce the Enterprise Value by adding the net debt to it. The EBITDA available will allow a comparison of the EV / EBITDA multiple of the public company and apply that same multiple to the companies being studied to deduce the Enterprise Value.

Precedent transactions are similar in principle, but somewhat more complicated. This method will look at recent M&A transaction that happened and look at the multiple applied for the transaction. Generally, less information will be available, making it more difficult to have the relevant data for comparison.

Application in debt financing

Once the value of the company has been calculated, either using the DCF or the EBITDA multiple - or often an average of both, a debt investor will be able to understand the LTV it will apply on the company. To give a concrete example, this is very similar to a mortgage: If you want to purchase a house that has been valued at 100 with 80 of mortgage, the LTV is 80%. Mortgage lenders also look at your salary and will for example lend up to 5x your salary. This is similar for debt financing: if the company has been valued at 100, a debt investor might be reluctant to have more than 80 of debt on the company and will not want to lend more than 5x the EBITDA of the company. However, this means that a lender will want to understand how much debt is “in front” of him – i.e., how much debt is senior to what the investor will lend to the company. This is important for them as, should a company default on its debt and start a liquidation process, debt investors will be repaid according to their seniority. The more debt is in front of them, the more risk of loss they will have.

Finally, another important cash flow element for bond investors is :

View attachment 153

This shows how many times a company can cover its interest expenses with its earnings. Lenders generally look to have at least 1.5-2x interest coverage ratio in case the business plan is lower than budgeted.

Great post, thanks!

I worked in KPMG's corporate finance team for two years, and when I got there I had no idea what was happening anywhere. I would open an excel spreadsheet and kick myself in the ass for not knowing every formula in every cell and how it connected with every other formula in every other cell and pretended to look smart for about 8 months. Then, something incredible happened: all of it suddenly clicked. Once the whole picture formed in my mind, I understood everything: the difference between debt and equity, how that related to the enterprise value, why we had (1 - t) in the WACC formula, how that related to equities quotes, why net debt was being subtracted from EV to arrive at equity value, and how and why we were applying discounts for lack of control (when valuing minority stakes) only to equity value.

I wonder if you had a similar experience? Or if anyone else here has?

 

[JustAnotherHuman1]

Great post, thanks!

I worked in KPMG's corporate finance team for two years, and when I got there I had no idea what was happening anywhere. I would open an excel spreadsheet and kick myself in the ass for not knowing every formula in every cell and how it connected with every other formula in every other cell and pretended to look smart for about 8 months. Then, something incredible happened: all of it suddenly clicked. Once the whole picture formed in my mind, I understood everything: the difference between debt and equity, how that related to the enterprise value, why we had (1 - t) in the WACC formula, how that related to equities quotes, why net debt was being subtracted from EV to arrive at equity value, and how and why we were applying discounts for lack of control (when valuing minority stakes) only to equity value.

I wonder if you had a similar experience? Or if anyone else here has?

I can only speak to software development (programming) which is a different endeavour from financial modeling but both are technical endeavours and so I have as well experienced these “aha” type moments during my journey to becoming a senior developer as I’m sure many others who don’t give up after the first hurdle that comes their way, in whatever craft they are working on. I wouldn’t describe it as an “incredible” moment though as I mean it was really just the culmination of hard work over the years that resulted in being able to see the big picture, since building scalable software is complex and requires good architecture. The other type of “aha” moment that you mention I think is the one that you feel after accomplishing a difficult task you didn’t know how to do before. And that comes from learning and years of experience working on different problems in nature.

 

[JFH1]

Great post, thanks!

I worked in KPMG's corporate finance team for two years, and when I got there I had no idea what was happening anywhere. I would open an excel spreadsheet and kick myself in the ass for not knowing every formula in every cell and how it connected with every other formula in every other cell and pretended to look smart for about 8 months. Then, something incredible happened: all of it suddenly clicked. Once the whole picture formed in my mind, I understood everything: the difference between debt and equity, how that related to the enterprise value, why we had (1 - t) in the WACC formula, how that related to equities quotes, why net debt was being subtracted from EV to arrive at equity value, and how and why we were applying discounts for lack of control (when valuing minority stakes) only to equity value.

I wonder if you had a similar experience? Or if anyone else here has?

Very much so, both in relation to valuation methodologies and subjects such as economic interactions. I am however a sceptic on many methodologies, including DCF, as I believe that it introduces a potentially misleading idea that an output must be reliable because it has calculated inputs. In reality, many of these inputs are quite subjective (cost of equity and terminal value, for example), and a small adjustment in these can create a very different outcome. I am particularly sceptical about terminal value, where the terminal growth rate is really just a best guess and the terminal value can be the largest component of the valuation (after you have sweated blood to do a five year cash-flow forecast). As a former fund manager, I am quite certain that some equity analysts would effectively reverse-engineer the DCF valuation to support their investment thesis, which is quite easy to do (either deliberately or through unconscious bias).