WCM Educational Recap #5: Value Investing

Recapped by Morgan Tannis

Value Investing

Welcome back to the Western Capital Markets blog! This week we reviewed the methods and tools used to value companies.

Introduction to Valuation

Valuation methodologies help estimate whether a company is overvalued or undervalued

Applications of valuation

• M&A Situations
• Initial Public Offerings
• Investment Decisions

Valuation methodologies

• Relative Valuation: Comparable Companies Analysis (Trading Comps), Precedent Transactions
• Intrinsic Valuation: Discounted Cash Flow (DCF) Analysis

Equity Value vs. Enterprise Value

Equity Value (Market Capitalization)

• Value of everything the company owns, including non-core assets such as cash, to common shareholders
• Equity value = Total Number of Shares Outstanding x Share Price

Enterprise Value (EV)

• Value of core business operations, to all investors
• Enterprise Value = Equity Value — Cash and Cash-Like Items — Equity Investments — Non-Core Assets + Total Debt + Capital Leases + Preferred Stock + Noncontrolling Interest + Non-Core Liabilities

Multiples

A measure of value divided by a driver of value

Common Multiples

• Enterprise Value / Revenue
• Enterprise Value / EBITDA
• Enterprise Value / EBIT
• Price Per Share / Earnings Per Share

Relative Valuation

Estimating value from the market prices of peers; includes Comparable Company Valuation and Precedent Transaction Valuation

Comparable Company Valuation

Using multiples of public peers to estimate firm value

Advantages

• Simple to use
• Does not make assumptions about the future
• Based on actual data which reflects current market trends and economic conditions

Disadvantages

• No company is 100% comparable to another company
• Multiples may be higher or lower depending on erratic market movements
• Share prices for small companies with thinly traded stocks may not reflect their full value

Criteria

• Geography
• Industry Classification
• Financial Criteria

Precedent Transaction Valuation

Using historical M&A transactions involving similar companies to estimate firm value

Advantages

• Simple to use
• Based on actual acquisitions and data

Disadvantages

• Market changes across time
• Scarcity of data
• No two acquisitions are 100% comparable

Criteria

• Geography
• Industry Classification
• Financial Criteria
• Transaction Date

Relative Valuation Process

• Step #1: Find comparable companies and transactions using selection criteria
• Step #2: Choose appropriate financial metrics and multiples for the set
• Step #3: Calculate multiples for all companies and transactions
• Step #4: Calculate the minimum, 25th percentile, median, 75th percentile, and maximum for each valuation multiple in the set
• Step #5: Apply selected multiples to company financials to estimate the valuation range

DCF Intrinsic Valuation

Valuing companies at the present value of their future cash flows

Characteristics

• Requires many assumptions
• Inputs are extremely sensitive
• Requires historical performance data

Stages

• Stage #1: Projection period
• Stage #2: Terminal value
• Stage #3: Valuation and implied share price

Stage #1: Projection Period

There are two types of projections when estimating future revenue and cash flows

• A top-down projection starts from revenue and works down to unlevered cash flow
• A bottom-up projection starts with unlevered cash flow and moves up to revenue

Unlevered FCF vs Levered FCF

• Unlevered FCF is money before paying debts and liabilities
• Levered FCF is money after paying debts and liabilities

Unlevered FCF is used because it is capital structure neutral which makes it easier to compare companies with different capital structures

Stage #2: Terminal Value:

Estimating value after the projection period when cash flows cannot be reliably determined

• Calculate the discount rate (usually WACC)
• Determine the present value of the cash flows at the end of the projection period
• Calculate the terminal value using either the Gordon Growth Method or the Exit Multiple Method

Stage #3: Valuation and Implied Share Price

Calculating final valuation and implied share price from the projection period and terminal value

• Combine the value of the projection period and the terminal value
• Calculate the enterprise value, implied share price, and resulting upside
• Determine if the company is overvalued or undervalued

Discount Rates

Because of the time value of money, the estimated cash flows in a DCF need to be discounted back to their present value

WACC

Represents the cost of financing and is the typical discount rate used in DCF analysis. WACC is composed of the cost of equity and the tax-adjusted cost of debt

• Cost of Debt = (1 — Tax Rate) x Interest Rate on Debt
• Cost of Equity = Risk-Free Rate + Market Risk Premium x β

Cost of Equity Components

• The risk-free rate: The interest rate on 10 to 30-year US government bonds. This rate is “risk-free” because every business is riskier than the US government
• The market risk premium: The riskiness of the market over and above that of the US government
• Beta: A measure of a security or portfolio’s systematic risk relative to the market

Systematic risk

• Systematic risk is the probability of a loss associated with the entire market
• Includes events that affect every business such as COVID or a recession
• The asset and the entire market move at the same time

Alternative Valuation Methods

NAV Model

• The fair value of a company’s assets less its liabilities
• Good for asset-heavy industries such as real estate, oil & gas, and metals & mining

Liquidation Valuation

• The realizable value of a company’s assets less its liabilities
• Useful in bankruptcy situations

Sum of the Parts

• The sum of the value of each of the company’s separate segments
• Useful when a company has unique segments (i.e. a resource extraction segment and a logistics segment)

Football Field

Displays relevant metrics and valuation methodologies on a single graph

• Shows which methodologies are more aggressive or conservative and what the valuation ranges are
• A 52-week historical stock price range is included to determine if assumptions are aggressive or conservative
• Often, Precedent Transactions will generate the highest valuation because of premiums paid by buyers

Key Takeaways

• Equity Value is the value of an entire business to equity investors only; Enterprise Value is the value of core business operations to all investors
• Relative valuation methods include comparable companies and precedent transactions; intrinsic valuation methods include discounted cash flow (DCF) analysis
• A football field is used to compare relevant financial metrics and valuation methodologies to determine an appropriate valuation range