This is the most important skill to have in investing, especially when we live in a world with too many “great” ideas.
What is Valuation?
It is the art of valuing a company.
When is Valuation used?
Literally all the time. Most prominently in mergers and acquisitions, and financings.
Mergers and Acquisitions
If you advise the buyer, you need to give your client advice on the right price to pay. You don’t want to overpay, but you need to pay enough for the seller to be willing to accept your offer. This is similar to real estate, where the seller would hire a real estate agent to determine the price of the house from market value and comparables. Companies hire bankers when they are having these transactions. Bankers will advise the seller what would be the appropriate price, meaning there is a lot of price discovery. It would help if you priced it well, so the seller is willing to sell. As a seller, you are trying to extract as much value as possible for the shareholder from the buyer. The banker will perform a valuation exercise to support POV on what the company is worth, based on their assumption.
On the financing side, to run a business, you need money. When companies are not generating enough cash on their own, you can either do that by borrowing money, but if you’re not working and don’t have savings, this would be debt financing. Companies can raise through equity, so they don’t have to pay interest. They will sell a portion of the companies to raise money. If the company needs $20M to scale to the profitability point of the company, then they will raise that amount. And the company is worth $100M. You can sell 20% of the company if buyers are interested. Initially, you need $20M, but you won’t know how much you can sell and how much your company is valued.
These are the 2 common ways when valuation is used.
What does the valuation mean?
Valuation is very subjective. One person might think the company is worth $100M, but another person thinks it’s worth $50M. Then who is right? How do you know who is right? Neither of them is because it is subjective. When we value a company, we make a lot of assumptions on imperfect information we have, like forecasting how much money the company will make. Based on the estimate, we would come up with several how much the company is worth today. We can lot of information and uncertainty of how much the company will make in the future where you have contracts with customers on how much they will purchase. At other times, you won’t have lots of information because the company is private and early, so you don’t know how to forecast their business in the future because there are many risks ahead. If there is more information, you will feel more confident about the valuation, but you still need your best shot at the valuation no matter what the deal goes through.
In addition, different people have different opinions. What side of the table or you on — the seller or the buyer? For example, if you are a seller in real estate, you are more optimistic about what you think the house is worth. The seller would represent a higher valuation because they think they have a great product that will expand internationally, go to new markets, and how we are so much better than the other competitors. On the other side, the buyer would do the exact opposite thing where they want to buy companies as cheap as possible. They know that the seller is usually more optimistic and aggressive on the forecast, so the buyers usually take the seller’s forecast and discount it back, from 100% to 80% — let’s say. Depending on who is doing the valuation, you will get different biases. The company's valuation is whatever the price the seller and buyer can agree on, like a house where they have to meet in the middle. Sometimes, the buyer or the seller would have more leverage, but ultimately, the transaction must be agreed on 1 price, which will be the company’s valuation.
In conclusion, the valuation is only as good as the quality of inputs used to derive the answer (“Garbage in, garbage out”).
What’s the right way to value a firm?
This is a trick question because there is no “right” way! Although I mentioned that it is subjective and depends on different things, there are common ways to value a company:
- Trading comparables (aka trading comps, or trading multiples) — almost always used
- Transaction comparables (aka transaction comps, precedent transactions, M&A comps, transaction multiples, etc.) — Mostly, M&A deal
- Discounted cash flow (DCF) — almost always used
For all methods, you cannot spit out a number. You will spit out a range. Those 3 ranges can overlap, and you will draw a line down the middle where it cuts through all staggered bars and triangulate that it’s the most likely valuation for the company. We must use the best information that we have. We can also run sensitivity analysis to get a range on the valuation, meaning if there are lots of inputs and assumptions on how fast revenue is growing, margin structure, for every dollar of revenue you bring in, how much of that becomes profit (cost reduction allows 50% goes up to 60%, what happens to valuation then). You can sensitize the valuation based on new inputs to see what number will stick out. Usually, you sensitize what variables are most sensitive and are least certain about. Because of this, you shouldn’t confidently say what company is valued, but you should understand the drivers of the valuation going up or down.
Valuation is an art, not a science. By definition of subjective, it means that there is no right or wrong. The best we can do is use multiple valuation methodologies to triangulate what the ballpark number should be. Because we never have perfect information, we use the best information available to support our point of view. For this reason, we also run sensitivity analysis to get a range on the valuation, as opposed to a single price point.
What is most important is to know the assumptions you’re making in the valuation model, or in other words, what are the drivers for the different ranges you get?
Other Valuation Methodologies
These are less common and more advanced:
- Leveraged buyout model (aka LBOs, used for private equity transactions) — leveraged finance, financial sponsors group
- Break-up, sum-of-the-parts analysis (aka SOTP, used it you’re considering breaking up a conglomerate) — proctor and gamble, GE with multiple business units that do different things, so it is hard to value the entire thing, so they break into different units like consumer products, etc. If it is a different industry, you will value it based on that industry. In the end, you would add the sum of the parts together to get the valuation of the entire firm. If it is a good business, the sum of parts will be greater than individual business units separately.
- Liquidation value (for companies going out of business) — how much can you get it for when sold
- Premiums paid
The most fundamental concept you need to learn is equity value (market cap or market capitalization). For a public company, the equity value is share price x number of shares outstanding. If a company decides to buy another company, the seller’s equity value is essentially the aggregate dollar amount the buyer has agreed to pay to own all of the shares in the company. The equity value is the same thing for a private company — still share price x number of shares outstanding. However, because the shares are not publicly traded, it can be harder to value them.
If the company is public, you can buy or sell the company’s stock on the stock market. Each company has a stock price. 1 share of AMZN is $3000. Every company has a certain amount of shares outstanding. Today, AMZN’s market cap is 1.501T, so several shares outstanding = market cap/share price = 500 million shares outstanding. If someone wanted to come and buy all the stocks, it would be equity value.
As for private companies, shares are not traded on the stock market, so it is harder to value because you cannot point at the stock market and say the company is worth X. But private companies have their own valuation for stock options, 9A valuation, unless they are super young, so they might not have a valuation (the younger the company, the harder it is to value a company). We can use trading comps, transaction comps, and DCF to get a valuation.
This is the twin brother of equity value, which will both be used all the time. The best current market value of the assets, taking operating assets and liabilities to subtract them against each other and whatever the remaining balance was the net when we looked at the 3 financial statements of how we looked at the balance sheet so there assets, liabilities, and stockholders’ equity.
The next concept is close relative to equity value and is just as important. Enterprise value (aka EV, aggregate value, firm value, or total enterprise value). This metric represents the best estimate of the company’s net operating assets (“net” means we are adding assets and liabilities together so that they net against each other).
The balance sheet is broken out into:
- Operating assets and liabilities: used to run the core day-to-day business; driven by strategic, operational and investing decisions (i.e. investing in a new machine, buying raw material).
- Financial assets and liabilities: think about the cash, debt, and equity on the balance sheet; driven by a company’s financial strategy (should we raise capital through equity or debt?). This has nothing to do with the day-to-day operations of the company.
Enterprise Value = Market Cap + Net Debt
Enterprise value is the representation of the company’s net operating assets.
Net Debt = Debt-Cash and Cash Equivalents (net = when opposites cancel out each other)
When you have less debt than cash, then you have a negative balance and vice versa.
You can find both the items above on the balance sheet.
Debt is any interest-bearing liabilities and can include:
- Long-term debt (need to be repaid in 1 year or more)
- Short-term debt (need to be repaid in the next 12 months)
To understand why Enterprise Value = Market Cap + Net Debt, think of it as the amount of buyer is truly paying out of pocket to buy all of the seller’s shares since it’s taking on all of the cash and debt that’s already on the seller’s balance sheet and is coming over.
- If the seller has 10 shares outstanding at $10 per share, the equity value is $100
- However, the seller also has $10 of cash and $5 of debt, which means the buyer only paid $100-$5 or $95
Everything in valuation will be driven off multiples, which always have numerator and denominator where the numerator is either equity value or enterprise value.
It is hard to compare companies because it is similar to comparing apples to oranges. If one house is 1000 sqft and the other is 2000 sqft,
To compare the value of one company to another company, we use something called “multiples” to have a consistent way of looking at different companies across the board.
An easy way to think about this again, to think about buying houses. One common way to compare the prices of different houses is to look at $ per-square-foot — that is just another kind of “valuation multiple,” but used for houses.
- It’s the same thing as saying, how much are you paying for each square foot of space?
- Ex: In San Francisco, you might be willing to pay $1k per sqft. In Cleveland, you might only be willing to pay $150 per sqft. This is because the market thinks SF is better to live in. After all, it has more high-paying jobs, better weather, lifestyle, etc.
Similarly, you can do the same thing for companies, but just using a different set of multiples.
Some Common Multiples
You can value a company on revenue, EBITDA, P/E. These are the most common ones in the industry.
Revenue multiple (aka EV/Revenue or EV/Sales)
- Ex: Company A is worth 10x revenue, whereas Company B is only worth 5x revenue. That means you’re willing to pay twice as much to buy $1 of Company A’s revenue because you think Company A has better prospects.
EBITDA multiple (aka EV/EBITDA)
- Ex: Company A is worth 30x EBITDA, whereas company B is only worth 10x EBITDA. So if we value the companies off of EBITDA, you’re actually willing to pay 3x as much to buy $1 of Company A’s EBITDA, again because you think it has better prospects
Price/Earnings (aka P/E or Equity Value/Net Income)
- Ex: Company A is worth 50x earnings, whereas company B is only worth 25x earnings.
- P/E stands for price PER SHARE/earnings PER SHARE. It’s the same as taking Equity Value/Net Income and dividing both the numerator and denominator by the shares outstanding
- the numerator is equity value, not enterprise value
What other Multiples are there?
There are so many multiples because different types of businesses have different business models. Their financial statements will also look different. An airline company is very different from a biotech company. It would help if you used the right multiple for the right company
A financial metric (i.e. EBITDA) that is meaningful for one industry may not be meaningful for another industry. As such, different industries will be valued off of different types of multiples
EV/Revenue, EV/EBITDA, and P/E are common multiples used across multiple industries. Some other examples include (industry and commentary in paren):
- EV/EBITA (various; commonly used in media, gaming, chemicals, bus & rail in place of EBITDA when there are significant differences in asset financing and you want to account for the impact of depreciation)
- EV/EBITDAX (Oil & Gas; excludes exploration expenses)
- EV/EBITDAR (retail, airlines; used when significant rental/lease expenses incurred)
- P/BV (banks/insurance; shareholders equity is important for banks because it serves as buffer/protection for depositors)
- EV/FFO (real estate; mainly the US)
When to use Equity vs Enterprise?
As a reminder, we know the difference between equity value and enterprise value is the net debt, or the financial assets and liabilities (as opposed to operational)
The rule to remember:
- Enterprise value should always be compared against profits BEFORE interest
- Equity value should always be compared against profits AFTER interest
This is because if you think about the capital structure if there are both debt and equity in the company:
- Debt holders get paid first because they’re “senior” in the capital structure. If you borrow money from the bank, you need to generate enough profits to pay back the interest payments before you pay anyone else (including salaries to employees or dividends to shareholders)
- Equity holders (aka shareholders) only have access to any EXCESS cash left over AFTER the interest and taxes have been paid (i.e. net income)
This will allow you to compare apples to oranges based on multiples of equity or enterprise value.
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