Module #2

Valuation
 Introduction to Valuation
EQUITY VALUE VS. ENTERPRISE VALUE
If investment banking has a heart that keeps everything running, I’d say that heart is
valuation. Whether we’re helping businesses raise capital or advising them on mergers and
acquisitions (M&A), valuation is always involved. It is used to answer questions like, “Is a
company undervalued? Overvalued? Should one buy it now, sell it, or hold off and wait?”

If you want to value companies and model transactions, you need to understand Equity Value
and Enterprise Value first.

Equity Value, also known as Market Capitalization or Market Cap, is simply:

Equity Value = Share Price of the Company × Total Number of Shares

For example, if a company has 1,000 shares outstanding and each one is worth $10, then the
company’s Equity Value is $10 * 1,000, which equals $10,000.

Think of buying a company like buying a house. Equity Value is like the “sticker price” you see
on the sign in front of the house. Maybe the sign says the house costs $500,000. Similarly, a
company’s Equity Value might be $500 million (50 million shares * $10 per share).

But is that the true price to buy the house or the company? Definitely not! Truth be told, there
are extra costs like furniture, unpaid bills, and repairs that can change the effective price.
Similarly, when buying a company, the actual cost can be quite different from the sticker
price due to factors like:

• Debt that needs to be repaid upon acquisition.

• Excess Cash that we can claim for ourselves.

• Unfunded Pension Obligations and other Liabilities we’ll have to cover.

To account for these, we calculate Enterprise Value:

Enterprise Value = Equity Value + Debt + Preferred Stock + Minority Interests − Cash

Preferred stock is added because it represents a claim on the company's assets and earnings
that is senior to common equity. Therefore, to get a true picture of the total value of the
company (enterprise value), we need to account for this obligation.

Minority interest (also known as Noncontrolling interest) is the portion of a subsidiary’s equity
that is not owned by the parent company. This ensures that the enterprise value reflects the
total value of the entire business, including the parts owned by minority shareholders.

Cash and cash equivalents are subtracted because they are not part of the operational assets
of the business. Cash is considered a non-operating asset that can be used to pay down debt
or distribute dividends to shareholders. Since cash can be used to pay down debt, including
it in the enterprise value (EV) calculation would double-count it, as EV represents the value
of a company's core operations net of cash.

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 COMMON VALUATION METHODOLOGIES
There are basically two ways to value a company: relative valuation and intrinsic valuation.
Relative Valuation: This involves comparing a company to similar companies (Public Comps)
or recent M&A deals (Precedent Transactions) to estimate its value.

Intrinsic Valuation: This includes methods like Discounted Cash Flow (DCF) analysis, where
we estimate the net present value of a company’s future cash flows or assessing the value of
its assets minus liabilities.

So, when do you use each methodology? You’ll almost always use Public Comps and
Precedent Transactions for any industry because they are universally applicable. For example,
if you were buying a house or car, you’d look at what similar ones are sold for.

In most industries (like consumer/retail, tech, healthcare, and industrials), you’ll also use a
DCF analysis to value the company based on its cash flows. However, in some sectors, a DCF
isn’t as relevant because either “Free Cash Flow” isn’t a meaningful metric, or the industry is
asset-centric (like Commercial Banks, Insurance Firms, and Real Estate Investment Trusts).

There’s no single “best” methodology or exact number for a company’s worth—it’s subjective.
Instead, you use these methods to estimate a valuation range (e.g., “The company might be
worth between $900 million and $1.1 billion”).

Discounted Cash Flow

DCF CONCEPT AND WALKTHROUGH

DCF is a straightforward concept, though the technical details can be tricky. Also, for
simplicity, I will only explain about unlevered DCF.

The basic idea is to find the fair price of a stock by knowing the present value of a company’s
future cash flow. Money today is worth more than money tomorrow because you could invest
it and earn interest, so you discount future cash flows back to their present value to account
for this.

A DCF is usually divided into two parts: the discrete projection period (typically 5 or 10 years)
and the Terminal Value (the distant future). Here’s how you do it:

1. Project the company’s Free Cash Flows over a 5–10-year period.

2. Calculate the Discount Rate, usually using WACC (Weighted Average Cost of Capital).

3. Discount and sum up the Free Cash Flows.

4. Calculate the Terminal Value.

5. Discount the Terminal Value to its Present Value.

6. Add the discounted Free Cash Flows to the discounted Terminal Value.

Not too bad, right?

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 CALCULATING AND PROJECTING FREE CASH FLOW (FCF)
If you have a 3-statement model for the company, this process is simple: you can pull the
numbers directly. Here’s the step-by-step (Exhibit 1):

1. Project Revenue Growth: Estimate the company’s annual revenue growth for the next
5-10 years based on recent historical numbers.

2. Assume an EBIT Margin: Use historical margins to calculate EBIT (or Operating
Income). For example, if a company has $1 billion in revenue and a 5% EBIT margin, it
has $50 million in EBIT.

3. Calculate NOPAT (Net Operating Profit After Tax), sometimes people also call it EBIAT
(Earnings Before Interest, After Tax): Apply the company’s effective tax rate. For
example, if the tax rate is 24%, then NOPAT is $50 million * (1 - 0.24) = $38 million.

4. Project Key Cash Flow Items:

a. Non-Cash Charges: The main non-cash charges are Depreciation &

Amortization, but you may also project others, such as Stock-Based
Compensation. You add them back because they save the company on taxes
without actual cash outflow. You can make these percentages of revenue. For
example, if they were 5% of revenue, and the revenue is $1 billion, you’d add
back $50 million.

b. Capital Expenditures (CapEx): You estimate CapEx each year, which always
reduces cash flow. You might average previous years’ numbers, assume a
constant change, or make it a percentage of revenue. For instance, if CapEx is
$50 million, it reduces cash flow by $50 million.

c. Change in Net Working Capital (NWC): A DCF values a company based on the
cash flow available to its financial owners, not its cash balance. The logic
behind subtracting NWC is that whenever working capital increases on a net
basis, it uses cash. For example, growing inventory, accounts receivable, or
even stashing more money in the bank takes away available cash from
company owners. Conversely, if net working capital is shrinking, it suggests
that more cash is being freed up.

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 Exhibit 1: DCF NASDAQ: CSPI
DCF 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028
Revenue 79,061 61,793 49,208 54,361 64,647 68,429 72,432 76,669 81,154 85,902
% growth -21.8% -20.4% 10.5% 18.9% 5.9% 5.9% 5.9% 5.9% 5.9%

EBIT -826 -1,424 -1,362 -40 1,870 3,490 3,694 3,910 4,139 4,381
% margin -1.0% -2.3% -2.8% -0.1% 2.9% 5.1% 5.1% 5.1% 5.1% 5.1%

Taxes -71 384 444 50 -469 838 887 938 993 1,051
% of EBIT 8.6% (27.0%) (32.6%) (125.0%) (25.1%) 24.0% 24.0% 24.0% 24.0% 24.0%

NOPAT/EBIAT -897 2,652 2,807 2,972 3,146 3,330

D&A 416 1,105 1,036 935 931 1,177 1,246 1,319 1,396 1,477
% of sales 0.5% 1.8% 2.1% 1.7% 1.4% 1.7% 1.7% 1.7% 1.7% 1.7%

CapEx 832 230 98 234 277 340 279 297 346 365
% of sales 1.1% 0.4% 0.2% 0.4% 0.4% 0.5% 0.4% 0.4% 0.4% 0.4%

Change in NWC -4,222 -1,583 -263 1,705 -1,764 -1,753 -1,856 -1,964 -2,079 -2,201
% of sales (5.3%) (2.6%) (0.5%) 3.1% (2.7%) (2.6%) (2.6%) (2.6%) (2.6%) (2.6%)

Unlevered FCF 5,242 5,630 5,957 6,275 6,643

Present Value of FCF 4,839 4,796 4,684 4,555 4,450

Source(s): Created by Yusuf Saputra

DISCOUNT RATE (WACC)

After calculating Free Cash Flow, figuring out the Discount Rate can be confusing. Typically,
professionals use Weighted Average Cost of Capital (WACC) as its discount rate. We use
WACC to discount cash flows because it represents the average rate of return a company is
expected to pay its investors (both debt and equity holders) for using their capital.

By using WACC, we ensure that the discount rate reflects the riskiness of the company’s
operations and the return expectations of all its capital providers. This helps in accurately
assessing the present value of future cash flows, leading to better investment decisions. In
simpler terms, it gives us a balanced view of the cost of funding the business and helps
determine if an investment will generate enough returns to cover this cost.

The formula for WACC is:

WACC = (Cost of Equity × %Equity) + (Cost of Debt × %Debt × (1 − Tax Rate))

Let’s do it step by step (Exhibit 2):

1. Calculating the Cost of Equity

Equity costs the company something in two ways:

• If the company pays dividends to shareholders, it’s an actual cash expense.

• By issuing equity to others, the company is giving up future stock price appreciation
to someone else instead of keeping it.

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 To estimate the Cost of Equity, we use this formula:

Cost of Equity = Risk-Free Rate + Equity Risk Premium × Levered Beta

Risk-Free Rate: This is the interest rate we could earn by investing in a “risk-free” security, like
30-Year US Treasury notes. If you’re in another country, use the government bond rates there.

Equity Risk Premium: This is the extra return we could earn by investing in a stock market
index, like the S&P 500 or IHSG. It’s the reward for taking on more risk compared to “boring”
government securities. The idea of adding these 2 metrics is that while you could earn a small,
steady return from government bonds, investing in the stock market could give you higher
returns because it's riskier.

Beta: This measures the company’s risk relative to the entire market. If Beta = 1, the company
is as risky as the overall market. If the market goes up by 10%, the company’s stock will also
go up by 10%. You can use the company’s historical Beta for this.

2. Calculating the Cost of Debt

The cost of debt is basically the interest rate the company pays on its debt. Debt interest
payments are tax-deductible, so you multiply by (1 - Tax Rate). This makes debt cheaper than
equity or preferred stock because preferred dividends aren’t tax-deductible.

From the definition and the formula of WACC, we can infer some implications:

• Debt usually lowers WACC because interest rates on debt are lower, and interest is
tax-deductible.

• Preferred stock is cheaper than equity but not as cheap as debt.

• Equity costs the most because, over the long term, you’d expect to earn more from
the stock market than from bonds.

Also, Higher Risk-Free Rates and Equity Risk Premiums increase the Cost of Equity. Debt also
raises the Cost of Equity because it makes investing in the company riskier due to the
increased chance of default.

Once we’ve calculated the Discount Rate, we discount the company’s cash flows over the
projection period (5 years) and add them up.

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 Exhibit 2: Simple WACC Example

Weighted Average Cost of Capital Weigh

Risk Free Rate (RF) 2.79% (1)
Equity Beta 1.143 (2)
Equity risk premium (Rm - Rf) 5.75% (3)
Cost of Equity (Ke) 9.36%

Cost of debt 3.53% (4)

Tax rate 21.00%
After-tax Cost of Debt (Kdt) 2.79%

Percentage of Capital
Debt 3,611 6.3%
Equity 53,447 93.7%
Total capital 57,058 100.0%
Weighted Average Cost of Capital 8.94%
(1) As of Jan-14-2022, based on the current 10-year U.S. Treasury
(2) Based on a 5 year monthly equity beta
(3) Implied ERP average yield last 20 years
(4) Based on weighted average historical cost of debt

Source(s): UBS M&A Finance Accelerator

CALCULATING TERMINAL VALUE

After projecting the discrete 5-10 years cash flow, the next step is to determine the
company's value far into the future, known as Terminal Value. There are two main methods
to calculate Terminal Value:

Method 1: Multiples Method

This method assumes the company gets sold for a multiple of its financial metric. For
instance, if the company has $500 million in EBITDA in Year 5 and similar companies are
worth 10x EBITDA, the Terminal Value is $5 billion ($500 million * 10).

Method 2: Gordon Growth Method

While this method assumes the company keeps operating indefinitely and sums its future
cash flows. By using Gordon Growth method, we use this formula:

Final Year Free Cash Flow × (1 + Terminal FCF Growth Rate)

Terminal Value =
Discount Rate − Terminal FCF Growth Rate

Basically, the value from this formula will reflect the cash flow of the company from, for
example, year 5, into year infinity, or we call it until perpetuity.

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 Which Method to Use?

There’s no “best” method. Both have their challenges because the key variables—Terminal
Multiple and Terminal Growth Rate—are hard to pinpoint.

If the industry is cyclical or multiples are unpredictable, the Gordon Growth method might
be better. If multiples are easier to estimate, the Multiples Method might be better.

I usually prefer the Gordon Growth method, but if asked on the spot, I’d use a simple multiple
like 10x EBITDA.

Now, once you have the Terminal Value, discount it using the same Discount Rate, and add
it to the discounted value of the company’s Free Cash Flows. This gives you the Enterprise
Value (with Unlevered FCF) or Equity Value (with Levered FCF). Then, you can figure out the
company’s implied per share price.

Remember, this is just a baseline calculation—you should always show a range of values
using a sensitivity table (Exhibit 3).

Exhibit 3: Sensitivity Analysis NASDAQ: CSPI

Terminal Growth Rate

17.82 3.50% 4.00% 4.50% 5.00% 5.50%
7.00% 19.91 22.45 26.00 31.34 40.23
7.50% 17.73 19.60 22.09 25.58 30.82
WACC
8.34% 15.09 16.30 17.82 19.80 22.47
8.50% 14.69 15.81 17.21 19.01 21.41
9.00% 13.58 14.48 15.58 16.96 18.73
Fair Value

Source(s): Created by Yusuf Saputra

Multiples/Comparables
SPECIFIC MULTIPLES TO USE
As we already discussed, there’s no best method on valuation and there is no “correct”
number that tells you the actual value of the company. In this section, I will explain how to
use comps to value a company.

When analyzing a company, you'll typically calculate both Equity Value and Enterprise Value.
The exception is in industries like commercial banking and insurance, where only Equity
Value is meaningful (refer to industry-specific lists for more details). It’s not about which one
is more useful since you’ll almost always consider both. The real questions are: What do they
mean, and when do you use each one?

Throwing back, Equity Value is like the "sticker price" of a company, while Enterprise Value
reflects how much it would actually cost to acquire. Their usage depends on what's in the
denominator when calculating valuation multiples. If the denominator includes interest
income and expense, use Equity Value; if it doesn’t, use Enterprise Value.

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 Here’s a list of key metrics you might use in the denominator of valuation multiples and what
you should pair them with in the numerator:

• Revenue: Enterprise Value. E.g., EV/Revenue

• EBIT (or Operating Income): Enterprise Value. E.g., EV/EBIT

• EBITDA: Enterprise Value. E.g., EV/EBITDA

• Net Income (EPS): Equity Value (Per Share Price). E.g., P/E

• Unlevered Free Cash Flow (Free Cash Flow to Firm): Enterprise Value. E.g.,
EV/Unlevered FCF

• Levered Free Cash Flow (Free Cash Flow to Equity): Equity Value. E.g., Equity
Value/Levered FCF

When in doubt, ask yourself, "Does this include interest income and expense? Do we subtract
interest expense and add interest income to get this metric?" If it does, use Equity Value; if it
doesn’t, use Enterprise Value.

INDUSTRIES SPECIFIC MULTIPLES

The multiples you use are highly dependent on the industry you're analyzing and the
company's stage of growth. Generally, you'll use a Revenue Multiple (Enterprise Value /
Revenue), which measures how valuable a firm is relative to its Net Sales, and a Profitability
Multiple to assess how valuable it is relative to its profits (P / E, EV / EBITDA, EV / EBIT, EV /
Unlevered FCF, or Equity Value / Levered FCF, each measuring different aspects).

Often, using two or more Profitability Multiples gives a better perspective on a company's
value. I also recommend building a football field graph to visualize this perspective.

Here’s a table to summarize some commonly used multiples (Exhibit 4):

Exhibit 4: Commonly Used Multiples

Multiple Name Used For What Does It Mean
Rough approximation of a company's value
Many types of companies; most useful where CapEx is
Enterprise Value / EBIT relative to its income from business
important (D&A follows Capex closely)
operations

Enterprise Value / Many types of companies; useful where CapEx and D&A are Rough approximation of a company's value
EBITDA less important (excludes both) relative to its operational cash flow

Many types of companies; most relevant for banks and

Rough measure of a company’s value in
P/E financial institutions; affected by non-cash charges, capital
proportion to its after-tax earnings
structure, and tax rates

Equity Value / Levered Not very common; requires more work to calculate and may Most accurate measure of a company's true
FCF vary greatly with capital structure "cash flow" and its value relative to that

Used when CapEx or changes in Operational Assets and Similar to Levered FCF but capital structure-
Enterprise Value /
Liabilities (e.g., Deferred Revenue) have a big impact; critical neutral, better for comparing different
Unlevered FCF
in DCFs companies

Source(s): Corporate Finance Institute

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 P / E is probably the “worst” (or at least, “least accurate”) multiple due to its inclusion of non-
cash charges and impact by tax rates and capital structures. It's more common among the
general public than finance professionals. So, I guess now you know what metrics you can
use to resemble those professionals.

Depending on the industry, specific multiples may be required:

• Retail, Restaurant, and Airlines: EV / EBITDAR (R stands for “Rent”) is used for
comparability because some companies own buildings and others rent them.

• Oil& Gas Companies: EV / EBITDAX (X stands for “Exploration”) is used for

comparability since some companies capitalize exploration expenses, while others
expense them on their Income Statements. EV / Proved Reserves and EV / Daily
Production multiples are also common because they are crucial in energy.

• Real Estate: P / FFO (Funds from Operations) per Share and P / AFFO (Adjusted Funds
from Operations) per Share multiples are preferred over P / E for REITs as they add
back Depreciation and Gains / (Losses), which are significant non-cash charges.

• Internet Companies: Multiples like EV / Unique Visitors or EV / Registered Users are

common if the company has not yet reached profitability or isn't generating revenue.

And the list goes on. In fact, you can create a valuation multiple from almost any metric, for
EV EV EV
example, , , and
# of Beds in Healthcare Subscribers in Telecom Passenger Miles for Aerospace & Defense

USE OF MULTIPLES
But how exactly can we use this metric to get the value of the company?

Back in early 2024, Keane and I used this valuation approach to win an investment banking
competition in one of the biggest investment banks in Canada. Here's a recap of how we
valued the brand Timberland, which had an EBITDA of $166 million. We focused on its
competitors within the same industry (worker boots) and used the EV/EBITDA metric.

First, we compiled data on the competitors' EV and EBITDA. Second, we calculated each
company's EV/EBITDA. Third, we took the median/mean, 25th percentile, and 75th percentile
of these values to later determine the base, worst-, and best-case Enterprise Value (EV) of
Timberland.

One thing good to note is that, if there was a significant difference in the EV/EBITDA
numbers—for example, if most metrics were between 4x and 8x but one company had a 32x
EV/EBITDA—it was better to use the median. This is because the median accounts for outliers,
giving a more accurate reflection of the typical valuation.

Lastly, with this information, we simply multiplied Timberland's EBITDA by the calculated
EV/EBITDA values to get the Enterprise Values (EV) (Exhibit 5).

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 Exhibit 5: Valuing Timberland using Comps ($in mm)
Peers Market Cap EBITDA EV EV/EBITDA Base Case EV Timberland $1,050.80
Dr. Martens plc $1,160.00 $245.00 $1,143.80 4.67 Best Case EV Timberland $1,276.83
Caleres, Inc. $1,385.00 $268.10 $1,685.00 6.28 Worst Case EV Timberland $859.29
Boot BarnHoldings, Inc. $2,626.00 $315.60 $2,566.00 8.13
Urban Outfitters, Inc. $4,126.00 $525.00 $3,347.00 6.38
Wolverine World Wide $809.40 $51.20 $1,686.40 32.94
Buckle, Inc. $1,959.00 $347.00 $1,668.00 4.81
Median 6.33
Mean 10.53
25th Percentile 5.18
75th Percentile 7.69
Timberland $166.00

Source(s): Created by Yusuf Saputra

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