WCM Educational Recap #9: Introduction to Valuation

Recapped by Andre Corona

Valuation

This week, we built upon the concept of value investing with an introduction to some of the different valuation methodologies, an overview of multiples, and a look at DCF analysis.

Introduction to Valuation

Real-Life Applications of Valuation:

1. M&A Situations
2. Initial Public Offerings
3. Investment Decisions

Common Valuation Methodologies:

What is Intrinsic Valuation?

Intrinsic valuation determines an asset’s value as the sum of cash flows produced by that asset, over its useful life, discounted for the time value of money and the uncertainty of receiving those cash flows. The benefit of using intrinsic valuation is that it includes detailed future expectations and assumptions about a company’s business activity, which means that it does not require relative valuations of competitors. Although intrinsic valuation can be very useful, it is also sensitive to changes in assumptions and does not factor in current market events.

What is Relative Valuation?

Relative valuation aims to determine what a business is worth, based on the value of its competitors. By looking at industry average data, one can determine what a company should be worth and decide whether the business is overvalued or undervalued relative to its competitors. Relative valuations are often quicker and easier to put together than an intrinsic valuation, and price in current market events since they are based on public market data. On the other hand, relative valuation has limitations because of the idea that no two companies are 100% comparable, so a direct comparison of multiples is not always ideal.

What is the Value of a Company?

You can’t precisely determine the value of a company because you are missing two critical pieces of information:

1. Which parts of the company do you want to value?
2. To which group of investors do you want to determine the company’s value?

The answers to these questions result in two different methods for determining a company’s value, which is Equity Value and Enterprise Value.

Equity Value vs. Enterprise Value:

Equity Value is the value of everything the company owns, including non-core assets such as cash, only to equity investors. Equity Value = Total Number of Shares Outstanding x Share Price. Meanwhile, Enterprise Value (EV) is what the core business operations are worth, but to all investors, including common and preferred shareholders, and creditors.

Multiples

What is a Multiple?

A multiple is a measure of how much the market is valuing a company relative to the value stakeholders are receiving. Multiples are used to quantify a company’s growth, productivity, and efficiency, relative to its share price. Multiples are made up of two components:

1. Measures of Value: The numerator in the ratio is a measure of the value of the business such as Enterprise Value or Equity Value.
2. Drivers of Value: The denominator is a metric that measures some aspect of company performance, such as revenue, EBITDA, or net income

Commonly Used Multiples:

1. Enterprise Value / Revenue: How valuable a company is relative to its overall sales.
2. Enterprise Value / EBITDA: How valuable a company is relative to its operational cash flow. This ratio is useful when CapEx and D&A are not important.
3. Enterprise Value / EBIT: How valuable a company is relative to its pre-tax profit from its core business operations. This ratio is useful when CapEx is an important factor.
4. Price Per Share / Earnings Per Share (P/E Ratio): How valuable a company is relative to its after-tax profits, inclusive of interest income and expenses. This is the least accurate multiple since it is distorted by non-cash charges, capital structure, and tax rates.

Relative Valuation Methods

Comparable Company Valuation:

The comparable company valuation looks at ratios of similar public companies and uses them to derive the value of another business. In order to make justified comparisons between two businesses, they must be located in a similar geography, be within the same industry classification, and have similar financial criteria.

Relative Transaction Valuation:

The relative transaction valuation looks at historical M&A transactions where entire companies were bought or sold, which demonstrates what an investor is willing to pay for an entire company. The benefit of this method is that it is based on actual acquisitions, meaning it does not make assumptions about the future. One thing to consider when using relative transaction valuation is that there can be a time lag between transactions, meaning the market could look very different and valuations could change

How to Apply Relative Valuation Methods:

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

Discounted Cash Flow Analysis

What is a Discounted Cash Flow (DCF)?

A DCF is a method of intrinsic valuation that ignores market noise. It assumes a company is worth the present value of all its future cash flows, which is determined through a discounted cash flow analysis.

Three Stages of a DCF:

1. Projection Period: The time that your forecast covers, which should extend until company operations are stable. This starts from revenue and ends with unlevered free cash flow.
2. Terminal Value: Calculate the discount rate (WACC), determine the present value of the cash flows at the end of the projection period, and determine the overall value of the company.
3. Valuation and Implied Share Price: Calculate the enterprise value, implied share price, and resulting upside to determine whether a company is under or overvalued.

Weighted Average Cost of Capital (WACC):

The WACC is the typical discount rate used in a discounted cash flow analysis and represents how much it costs the firm to receive funds through debt and equity. In other words, it is a numeric representation of the opportunity cost of investment. It is composed of the cost of equity and the tax-adjusted cost of debt.

Betas and Alternative Valuations

What is Beta?

Beta is the measure of a stock’s volatility, or systematic risk, of a security or portfolio in relation to the overall market. Beta can also be used to compare risk between multiple stocks. A higher beta means a stock is a riskier, more volatile investment.

Alternative Valuation Methods:

1. NAV Model: The fair value of a company’s assets less its liabilities.
2. Liquidation Valuation: The Realizable value of a company’s assets less its liabilities.
3. Sum of the Parts: Sum of the values of each of a company’s separate segments.