WCM Educational Recap #5 — Introduction to Value Investing

Recapped by Amy Zado

Welcome back to the WCM blog! If you missed this week’s educational, not to worry. This post is chock full of useful information for valuing companies, so be sure to give it a read through. We also encourage sign-ups for Week in Reviews and to keep an eye out on WCM’s Facebook page for more opportunities!

Week In Review

This week we explored the huge fluctuations of Grindr’s share price on the day they went public and the future trends that might be seen, alongside the FTX Crypto Exchange filing for bankruptcy due to the owner using customer deposits as collateral for his hedge fund, causing conversations of increased regulation in this space.

Introduction to Valuation

It’s difficult to determine what the value of a company is without considering these two questions:

1. Which parts of the company?
2. To which investors?

The Three Uses of Valuation

• Merger and Acquisition Situations
• Initial Public Offerings (IPOs)
• Investment Decisions

Two Methods to Value a Company

Equity Value: the total value of the company to all equity investors, representing everything the company owns

• EQV = # Shares Outstanding x Share Price

Enterprise Value: the total value of the core business operations to all investors, and so common preferred debt and cash must be accounted for

• EV = EQV — cash — equity investments — non-core assets + total debt + capital leases + preferred stock + non-controlling interest + non-core liabilities

Multiples

These compare how much the market values a company relative to the value stakeholders receive. It quantifies a company’s growth, productivity, and efficiency. You must always make sure the numerator and denominator take into account the same factors.

• Measure of Value / Drivers of Value
• Measures of Value: EQV or EV
• Drivers of Value: Revenue, Earnings, EBIT, EBITDA, etc.

EV/Revenue: How valuable is a company relative to overall sales?

EV/EBITDA: How valuable a company is relative to operational cash flow? — Often useful when CapEx and D&A are unimportant

EV/EBIT: How valuable is a company relative to its pre-tax profit from core business operations? — Often useful when CapEx is important

Price per Share/Earnings per Share (P/E): How valuable is a company relative to its after-tax profits? — Often the most potential for distortion

Price per Share/Earnings per Share Growth (PEG): adjusts P/E to the growth rate as investors are often willing to pay more for companies expected to grow more.

The Two Common Valuation Methods

Relative Valuation
This uses the value of close competitors and industry averages and multiples to determine what a company should be worth, and if it’s currently over or undervalued relative to competitors.

Comparable Companies Analysis
Compares the ratios of similar public companies (by geography, industry classification, and financial criteria), and then aggregates them to determine appropriate multiples for your company.

Advantages:

• Simple and quicker to use
• Reflects current market environment
• Not based on assumptions

Disadvantages:

• No company is 100% comparable
• Stock market is emotional
• Share prices for small companies may not reflect their full value/growth potential

Precedent Transactions Analysis
Uses the historical transactions of past acquisitions/sales of full companies similar to yours (by geography, industry classification, financial criteria, and transaction date) to determine what an investor is willing to pay.

Advantages:

• Simple to use
• No assumptions necessary
• Reflects current market environment

Disadvantages:

• Time lag between transaction record and now (market could look very different now)
• Lack of comparable transactions (unique deal terms, motivations, synergies, etc.)
• Information is not released to the public

Applying Relative Valuation Methods

1. Select companies and transactions based on some predetermined criteria
2. Determine appropriate metrics and multiples for each set
3. Calculate multiples for all companies and transactions
4. Calculate the minimum, 25th percentile, median, 75th percentile, and maximum for each valuation multiple in the set
5. Apply those to financial metrics for the company you’re analyzing to estimate the potential range for valuation

Intrinsic Valuation
We determine the value of all a company’s assets based on all future cash flows produced by them in their useful lives, and then discount it to present value to account for the time value of money (isolates the company from the market). Cash flows, the discount rate, and uncertainty are all critical concepts.

Advantages:

• Very detailed future expectations and assumptions
• Strong sensitivity analysis
• No relative valuations of competitors needed

Disadvantages:

• Difficult to make operating assumptions
• Very sensitive to any changes
• Difficult to estimate the WACC

Discounted Cash Flow (DCF) Analysis
This is broken down into three stages: the projection period, the terminal value, and the valuation and implied share price.

1. The Projection Period
Apply a top-down approach (from revenue to unlevered free cash flow) or a bottom up approach (vice-versa), considering estimated growth, macroeconomic trends, and management goals.

• Unlevered Free Cash Flow (UFCF) : money before paying for debts and liabilities
• UFCF = Net Operating Profit After Tax (NOPAT) + Depreciation & Amortization — CapEx — Change in Net Working Capital

2. Terminal Value
Weighted Average Cost of Capital (WACC) is the discount rate used in a DCF, which essentially represents the opportunity cost of investing in a security.

• WACC = Cost of Equity x Weight of Equity + Cost of Debt x Weight of Debt
• Cost of Equity = Risk Free Rate (RFR — return on no-risk investment like US 10Y T-Bond) + Market Risk Premium (MRP) x Beta
• Tax-Adjusted Cost of Debt = Interest Rate x (1 — Tax Rate)

Beta measures a stock’s volatility or systematic risk (only dependent on the market) in relation to the overall markets. It is found by dividing the movement of the stock by the movement of the market. To find it, we must do the following to eliminate the implications of the peers’ capital structures (debt vs equity financing).

1. Compile a list of peers and unlever each beta
2. Find the average of peers’ unlevered betas
3. Relever average beta using target company’s capital structure

After calculating the present value of future cash flows, we determine the overall value of the company using the Gordon Growth Method or the Exit Multiple Method.

3. Valuation and Implied Share Price
Calculate the enterprise value, implied share price, and resulting upside or downside.

• EV — Net Debt = EQV
• EQV/Number of Shares = Implied Share Price

As always, thanks for reading and we’ll see you next week!