Investment Banking Series
Post 4 Valuation, Part 1
1. What is it anyway?
Valuation is the process of calculating and otherwise assessing the Enterprise Value (in case of equity) or any other appropriate metric to be used as a base for setting the fair price range for the offering. Along with the distribution network, the ability to produce the appropriate valuation is supposed to be the core expertise of an investment bank. There are books out there that would give you much detail on the valuation techniques. The one I would personally recommend is Investment Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions
. It's a step-by-step easy to follow practical description. I do not intend to go anywhere that far, and will just introduce the important concepts here.2. The great myth and the not-so-impressive reality
Valuation is often rumored to be a highly numerical and sophisticated procedure, both science and art, requiring in-depth understanding of financial statements and issuer's business, as well as factoring in the market sentiment. Quite possibly, in some cases it is. However, in my practice it never went more sophisticated than three rather short sheets in Excel. Putting that aside, let's review the most common valuation techniques below (keep in mind, that I refer to equity offerings here).Comparable Companies Analysis (a.k.a. Comps)
Under this method a banker would calculate the average indicators for a number of comparable listed entities, and compare this average with the company being evaluated. Then he (or, less likely, she) would determine the fair value per share of stock to be offered, and this number, combined with the market sentiment and Sales opinion will be used to determine the price range. The procedure is relatively simple and does not require a degree in math. The real challenge is to select the appropriate peer companies, because the valuation results will be mostly influenced by this selection. This feature of the analysis is sometimes used by unscrupulous bankers to bring the valuation higher by consciously selecting the more expensive peers.The main metrics used for the analysis are P/E and EV/EBITDA ratios. Each has its strengths and weaknesses.
The attractiveness of the P/E Ratio (or Price-to-Earnings Ratio) is that it is easy to calculate:
P/E = Equity Market Value per Share/Earnings per Share
which in most cases can be translated into
P/E = Stock Price/Earnings per Share
There are two kinds of P/E - trailing and projected. The difference here is in the E part - either historical or forecast earnings are used. Earnings per Share (EPS) calculation can be somewhat bothersome if the company being valuated has a complicated capital structure with dilutive securities - securities that can be converted to shares, and thus increase the number of shares outstanding. Overall, P/E Ratio can be described as an indicator of investor's willingness to pay for the stock in anticipation of future earnings. Calculating the industry average P/E Ratio can provide an estimate of the price at which the company being valuated would be priced.
The advantage of EV/EBITDA multiple is that it allows to compare enterprises affected by different taxation policies and also considered a better indicator of company's earning power, as the non-cash expenses (Depreciation and Amortization) are added back to EBIT to produce EBITDA*. Also, EV is considered a better metrics as indicator of what a potential buyer would pay to take over the company, as opposed to Market Cap.
The disadvantage is that the calculation can be fairly complex, and the resulting metric is not very intuitive. Plus, the very advantage of EBITDA that it allows to compare different companies is a disadvantage if you are thinking of the stock in terms of returns on investment, as the actual returns are dependant on Net Income, not EBITDA.
*The DA part wasn't introduced into accounting without reason. At some point, company has to replace old equipment, so there will be commensurate expenses. But in the short term no cash outflows occur.
This concludes Part 1 of my Post 4 on investment banking. In Part 2 I will describe the DCF analysis.
Links to other posts in the investment banking series:
Post 1: Series Introduction
Post 2: Deal from Sourcing to Completion
Post 3: Pitch Books
Post 5: Valuation, Part 2
Post 6: Equity Story
Post 7: Roadshows
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