VALUATION: A CONCEPTUAL OVERVIEW

of Investment Banking Technical Training

In this chapter we will introduce the reader to some key, high-level concepts required to understand valuation and how it’s done on Wall
Street. We will cover three key topics:

• Enterprise Value: The 30,000-Foot View

• Understanding Enterprise Value vs. Market Value
• An Introduction to Valuation Techniques

Enterprise Value: The 30,000-Foot View

Investment bankers use four primary valuation techniques when advising corporate clients. These techniques apply almost universally,
regardless of the company, industry or circumstance. They will be introduced in the next chapter, Valuation Techniques Overview.

But how are the valuation techniques actually constructed? When should which technique be used? What are the basic building blocks
required for them? We will find more detailed answers to some of these questions in the next chapter. However first we’re going to take
a step back and explain some of the building blocks of these valuation techniques so that they make sense when we later discuss them in
technical depth.

In this chapter, therefore, you will find a detailed overview of the core building blocks of the valuation techniques used by investment
bankers.

Enterprise Value (frequently referred to as EV—not to be confused with Equity Value, which is another name for Market
Value of a company) is the core building block used in financial modeling. The reason is this: Enterprise Value is designed to represent
the entire value of the company’s operations. By contrast, Market Value is a residual: it represents the value of the company remaining
once the value ascribed to other stakeholders (non-owners) has been taken out.

Enterprise Value must therefore account for all of the differences between Market Value (remember, this figure is the Market Value of a
company’s Equity or ownership) and the Value of Operations (or Operating Value) of a Company.

Let’s start with a basic identity equation:

Enterprise Value =Operating Value of a Company =Net Value of all the Claims on the Company’s Assets (Excluding
Excess Cash)

This equation is simple enough. Assuming that the company is profitable, and that it’s more valuable in operation than in liquidation (in
other words, the company is worth more money if it continues in business rather than stopping business and selling off the assets to the
highest bidders), the value of the company is equal to the value of its productive operations. This value must also equal the value of all of
the net claims against the company’s assets, because these assets are being used to produce money for these claimants, or stakeholders
(assuming, of course, that these claims have been valued correctly). The “Excluding Excess Cash” piece will be explained in a moment.

The net value of all the claims on a company’s assets can be broken down as follows:

• Debt: Money that has been lent to the company by another person or institution. Debt holders have a higher priority than equity
holders on the claims of the company’s assets and value, so they get paid first. In order to get to EV, we must add Debt to the Market
Value of the company’s Equity.
• Cash: Money that is owned by the company—in other words, it’s sitting on the company’s balance sheet. This money, assuming it is not
required by the operations of the business, could be used to pay off existing claimants, or stakeholders. (For example, the cash could be
used to pay off Debt; it could also be used to repurchase outstanding shares in the company’s Equity.) Thus the higher the Cash balance
a company has, the less its operations must be worth. This concept is counterintuitive: shouldn’t owning more cash be a good thing?
Yes, in a sense it is—but assume for a moment that a company’s Market Value (of Equity) is fixed at a certain dollar amount. That value
can be ascribed to only two sources: (1) the residual claim value on a company’s operations after all other stakeholders have been paid
off, and (2) the value of the money on the company’s balance sheet. The higher (2) is, the lower (1) is, and vice versa. Therefore, to get to
EV, we must subtract Cash from the Market Value of the company’s Equity. (This is one way of looking at it. In practice, Cash is often
subtracted from Debt to get an important statistic called Net Debt. Net Debt is the value of the Debt once balance sheet Cash has,
hypothetically, been used to pay some of it off. Diagrams below will explain the different ways of conceptualizing this.)
• Minority Interest: This is a tricky one. Corporations often have a Liability account called Minority Interest (MI). This is a special
accounting designation for a specific scenario: when a Corporation owns most, but not all, of a subsidiary company. If that is the
case, the subsidiary company is consolidated entirely into the Corporation’s financial statements, so that it would appear, at first glance,
that the Corporation does indeed own 100% of that subsidiary. In fact it does not, so this Liability account is created to represent the
value of the shares owned in the subsidiary by other individuals or companies. (Similarly, there will be a corresponding Minority
Interest expense on the Income Statement for the Corporation, representing the portion of value from the subsidiary’s operating results
that actually belongs to the other shareholders in the subsidiary.) Since this MI represents the value of the partial ownership (by others)
in this subsidiary, it should be treated like Debt – that is, in order to get to EV, we must add Minority Interest to the Market Value of
the company’s Equity. (We should keep in mind, then, that this EV statistic will include the entire value of the company’s subsidiary,
even though the Corporation itself does not own 100% of it.)
• Preferred Equity: Despite the name, Preferred Equity primarily operates as Debt, not Equity. It is junior to all other forms of Debt,
but it is also senior to the Equity (often called Common Equity or just “common.”) Often, Preferred Equity can be converted to shares
of Common Equity, hence the name. It may be convertible to Common Equity but, until that time, it receives interest and is in line
ahead of the Common Equity in the capital structure, so it is “preferred” to the common shares. It receives preferential treatment.
Because Preferred Equity is actually primarily Debt unless and until it is converted to Equity, we must add Preferred Equity to the
Market Value of the company’s (Common) Equity.

Visually, we can look at this two different ways:

 1. ENTERPRISE VALUE + CASH = TOTAL VALUE OF ALL CLAIMS

2. ENTERPRISE VALUE = NET VALUE OF ALL CLAIMS

Typically, investment bankers and investors look at this equation the second way (the Net Debt/Net Value version). This is the one to be
most familiar with.

ANOTHER VIEW OF ENTERPRISE VALUE

There is another way of looking at EV: core assets vs. non-core assets. Core assets are used to generate profit for the business; non-core
assets are things owned by the business but not central to its money-generating operations.

• Core Assets: assets critical to the operating business, such as Inventory, Fixed Assets, Accounts Receivable, etc.
• Non-Core Assets: assets not critical to the operating business such as Derivatives, Currencies, Real Estate, Commodities, Stock
Options, etc.

In this sense, Cash on the Balance Sheet usually (at least for the most part) is non-core. Unless it’s cash that the business needs to
operate (such as dollar bills in the registers at a retail operations), it is not being used to generate profit in the business operations.
That’s why it is stripped out in EV calculations. (Other non-core assets may be as well, especially if they can be sold off for cash without
harming the operations of the business. For example, Real Estate and Commodities can often be sold without impacting the Company’s
cash-generating operations.)

Therefore Cash is (generally) a non-core asset. Other similar assets, such as Marketable Securities, are simply ways of attempting to
earn profit on that Cash, but are not core to the company’s operations. These Cash-like assets can also be sold off, and should be
stripped out of the Net Debt Calculation.

PRIMARY COMPONENTS OF NET DEBT

• (+) Short-Term Debt: Debt with less than one year maturity.
• (+) Long-Term Debt: Debt with more than one year maturity.
• (+) Debt Equivalents: Operating Leases and Pension Shortfalls.
• (–) Cash and Cash Equivalents: Cash, Money Market Securities, and Investment Securities

Notice in this list that “Cash and Cash Equivalents” is a subtraction from the calculation—Cash and Cash-like assets are thus a sort of
“anti-Debt.” Debt can also come in several different flavors, but on the Balance Sheet it’s almost always broken down into Short-Term
Debt and Long-Term Debt. This is because Short-Term Debt is coming due soon (within less than a year), and thus must be paid off or
refinanced in the near future. This may be of interest if the company is having financial trouble—the due date on the near-term Debt
may trigger difficulties for the Company in terms of repayment. This type of difficulty, which can end up being a crisis under the right
circumstances, is called a liquidity problem (or crisis).

Understanding Enterprise Value vs. Market Value

Nearly all valuation techniques will focus on either Enterprise Value or Market Value (or Equity). So which do we use, and when? In a
nutshell:

Techniques related to the value available to shareholders should focus on Market Value (of Equity).
Similarly,
Techniques related to the value available to all stakeholders should focus on Enterprise Value.

Let’s start by looking at three commonly used trading multiples:

• EV/Sales: Enterprise Value ÷ Sales (or Revenue)

• EV/EBITDA: Enterprise Value ÷ EBITDA (Earnings before Interest, Taxes, Depreciation & Amortization)
• Price/Earnings (or P/E): Market Value of Equity ÷ Net Income (alternatively, Stock Price ÷ Earnings Per Share, or EPS)

Notice that in the first two examples, Enterprise Value is used. This is because Sales and EBITDA generate profit/value that is available
to all stakeholders. No compensation has yet been taken out for non-Equity stakeholders. By contrast, Price/Earnings reflects the Net
Income for a company, which is computed after compensation for other stakeholders has been removed (Interest Expense and
Minority Interest). Therefore, this profit/value is only available to Equity stakeholders.

People new to valuation may ask, “Why is it incorrect to use Market Value/EBITDA or Enterprise Value/Net Income?” The answer lies
in the fact that for any multiple, the denominator and numerator within that multiple must either include or exclude leverage. In other
words, both the numerator and denominator must both relate to either all stakeholders or only shareholders. Otherwise, comparisons
across companies will not be “apples-to-apples”—they will be difficult to compare because different companies utilize different amounts
of leverage.

This concept is demonstrated in the following graphic:

In summary:

Enterprise Value matches with Revenue, EBITDA and EBIT—items found before Interest Expense (and Minority
Interest, where applicable) on the Income Statement.
Conversely,
Market Value matches with Pre-Tax Income (sometimes called Earnings Before Taxes, or EBT), Net Income, and
Earnings Per Share—items found after Interest Expense (and Minority Interest, where applicable) on the Income
Statement.

An Introduction to Valuation Techniques

You will read about the four main valuation techniques for Investment Bankers in great detail in the upcoming chapters. Here is a brief
overview of them all, with this concept of Enterprise Value vs. Market Value in mind:

COMPARABLE COMPANY ANALYSIS

• Comparable Company Analysis, frequently referred to simply as “Comps,” is a valuation technique used to find company values
based on traded values of similar (comparable) companies.
• Comps a market-based valuation analysis relying on current market prices for publicly traded companies.
• Comps valuation can revolve around either the Enterprise Value of the company or the Market Value of the company, depending
on the multiples being used. For example, EV/Sales or EV/EBITDA multiples would refer to Enterprise Value, while Price/Earnings
multiples (equivalent to Market Value/Net Income) would refer to Market Value.

THE THREE MAIN STEPS OF A COMPS VALUATION

1. Identify publicly-traded companies with characteristics similar to those of the company being valued.
2. “Spread” the Comps—i.e., map-out the trading multiples (EV/Sales, EV/EBITDA, and P/E) for this set of comparable companies.
3. Assign these multiples to company financial results to determine valuation ranges.

COMPARABLE COMPANIES ANALYSIS EXAMPLE

• ABC Company is currently generating annual Net Income of $150 million.

• Publicly traded comparable companies are trading, on average, at 10x current year Net Income.
• How much is the Equity of this company worth?
 Using Comparable Company Analysis, this company’s Equity is worth $1.5 billion based on $150 million of Net Income and the
comparable company average of 10x Net Income. Note that a proper range of the valuation can be obtained by looking at the highest
and lowest Net Income multiples in the comparable companies set.

DISCOUNTED CASH FLOW (DCF) ANALYSIS

• DCF analysis values a company by projecting its future Free Cash Flows (FCF) and then using the Net Present Value (NPV)
method to value the firm.
• DCF valuation builds off of Free Cash Flow forecasts that are typically done for the upcoming 5 to 10 years.
• DCF valuation primarily returns the Enterprise Value of the company, because Free Cash Flow refers to the cash generated by the
operations of a business, irrespective of Net Debt and Minority Interest/Preferred Equity. However a DCF model can also be used to
project Market Value if Interest Expense and Minority Interest are projected and stripped out to produce Levered Free Cash
Flows (LFCF).

THE FOUR MAIN STEPS OF A DCF VALUATION

1. Forecast out a company’s Free Cash Flows for the next 5-10 years.
2. Calculate the Weighted Average Cost of Capital (WACC).
3. Calculate the firm’s Terminal Value, or the future value of the firm assuming a stable long-term growth rate.
4. Discount 5-year Free Cash Flows plus Terminal Value back to Year 0 (today) to derive the Enterprise Value of the company.

Free Cash Flows are discounted back to Year 0 (today) to solve for Enterprise Value, as displayed in this graphic:

PRECEDENT TRANSACTION ANALYSIS

• Precedent Transaction Analysis, also called “Comparable Transactions,” looks at recent historical M&A activity involving similar
companies to get a range of valuation multiples.
• This transaction valuation analysis relies on whatever historical M&A transaction information is available.
• Precedent Transaction valuation can revolve around either the Enterprise Value of the company or the Market Value of the
company, depending on the multiples being used. For example, EV/Sales or EV/EBITDA multiples would refer to Enterprise Value,
while Price/Earnings multiples (equivalent to Market Value/Net Income) would refer to Market Value. The most commonly used
transaction multiples are EV/Sales, EV/EBITDA, and P/E.

THE THREE MAIN STEPS OF PRECEDENT VALUATION

1. Identify publicly traded companies with similar characteristics.

2. “Spread” the comps or map-out trading multiples such as EV/Sales, EV/EBITDA, and P/E.
3. Assign industry multiples to company figures to determine valuation ranges.

PRECEDENT TRANSACTION ANALYSIS EXAMPLE

• PDQ Company is currently generating annual Net Income of $150 million.

• Precedent M&A transactions since 2004 have shown industry average of 20x P/E (see image below).
• How much is the Equity of this company worth?

Using Precedent Transaction Analysis, PDQ’s Equity is worth $3.0 billion based on $150 million of Net Income and the precedent P/E
multiple of 20x Net Income. Note that a proper range of the valuation can be obtained by looking at the highest and lowest Net Income
multiples in the precedent transactions set.
• Income Statement: Reports a snapshot of a company’s business performance over a period of time. This statement indicates how
much revenue (sales) is generated by a business, and also accounts for direct product costs, general expenses, Interest on Debt, Taxes,
and other expense items. The purpose of this statement is to show the company’s level of profitability, which is equal to a company’s
Revenue net of its expenses.
• Balance Sheet Statement: Reports a snapshot of a company’s outstanding balances in various accounts at a specific point in time.
The purpose of this statement is to demonstrate a business’s financial heath at any given time, by enumerating it assets as well as the
claims against them (liabilities and equity).
• Statement of Cash Flows: Reports on all of the company’s activities that affect its cash position over a period of time. These
activities are broken down into three primary categories: Operating, Investing, and Financing. The purpose of this statement is to give a
detailed reconciliation of how the company’s Cash is being used (and how much Cash is being generated).

INCOME Statement
• Revenue represents the sales brought in from selling a product or performing a service.
• Cost of Goods Sold (COGS) represents direct costs of producing goods and services that the business has sold, such as
material costs and direct labor.
• Selling, General, & Administrative Expense (SG&A) represents expenses associated with selling products and managing
the business. This will include salaries, shipping, insurance, utilities, rent, compensation for executives, etc.
• Depreciation & Amortization (D&A) represents the expenses associated with fixed assets and intangible assets that have
been capitalized on the Balance Sheet. D&A that is directly related to production will generally be included in COGS and will be
separated out on the Statement of Cash Flows (more on this later).
• Net Interest Expense represents the total Interest paid on Debt liabilities, net of the total Interest received on Cash assets.
• Tax Expense represents the amount of taxes paid.
• Net Income represents the company’s profit, which is Revenue minus all of the aforementioned costs and expenses.

The perspective of a financial analyst, the most important Balance Sheet line items fall into the following categories:

• Cash (Asset): Money owned by the company. For accounting purposes, Cash generally includes currency and coins on hand, checking
account balances, and undeposited customer checks.
• Current Assets: Assets whose value is expected to translate into Cash in the near future (generally within one year). Cash is a Current
Asset. Most Current Assets besides Cash are classified as “Operating Assets,” or Assets generated by the company as part of the
functioning of its business operations.
• Other or Long-term Assets: Assets whose value will not translate into Cash in the near future (outside of one year). Most Long-term
Assets are classified as “Operating Assets,” or Assets required by the company as part of the functioning of its business operations.
• Debt (Liability): An obligation (almost always interest-bearing) that represents borrowed money that the company must repay. Debt
is usually part of Long-Term Liabilities (see below), although any portion of Debt which must be repaid within the next year will be
classified as a Current Liability.
• Current Liabilities: Liabilities that a company must meet (via payment) in the near future (generally within one year). Most Current
Liabilities (other than Debt) are classified as “Operating Liabilities,” or Liabilities generated by the company as part of the functioning
of its business operations.
• Other or Long-term Liabilities: Liabilities that do not need to be met (via payment) in the near future (outside of one year). Most
Long-term Liabilities are classified as Debt, although some qualify as “Operating Liabilities,” or Liabilities generated by the company as
part of the functioning of its business operations.
• Shareholders’ Equity: The difference between Assets and Liabilities. This represents the value of the company’s assets after all
outstanding obligations have been paid off. This value accrues directly to the company’s owners, or Shareholders.

Note that the difference between Current Assets and Current Liabilities is referred to as “Working Capital” or “Net Working Capital,”
while the difference between Operating Assets and Operating Liabilities is referred to as “Operating Working Capital.” Working Capital
is an important consideration in financial modeling—this is particularly true of Operating Working Capital.

THREE PARTS OF A CASH FLOW STATEMENT

All Cash flows can be broken down into one of the important categories:

• Operating Activities: The Cash generated/used by a company’s business operations. This includes earnings delivered by the
company as well as payments collected from its customers. In its simplest form, Cash Flow from Operating Activities (CFO) will equal
Net Income + Depreciation & Amortization – changes in Operating Working Capital.
• Investing Activities: The cash generated/used by a company’s investment in assets. Cash Flow from Investing Activities (CFI)
includes the purchases of Fixed (long-term) Assets and maintenance of those Assets (Capital Expenditures), payments made for M&A
activities (usually acquisitions of other companies), or Cash generated by Marketable Securities or other non-operating uses of Cash.
• Financing Activities: The Cash generated/used by a company’s financing of its operations. Cash Flow from Financing Activities
(CFF) includes the Cash inflows from shareholders and lenders as well as the outflows of dividends or sales of stock. Items found in this
line item will include: Dividends Paid, Cash raised via the sale of Common Stock, Cash proceeds from Borrowings (Debt), and
repayment of Debt obligations.

In summary, Assets are uses of Cash while Liabilities and Equity are sources of Cash. This important concept will come into play directly in building
financial models that help determine a company’s value.

How Financial Statements Tie Together

Now that you are familiar with the three main Financial Statements, we can ascertain how they all tie together. In short, the Financial
Statements are interconnected in many places. In particular, practically every line item on the SCF is connected to one of the two other
statements.

CONNECTED LINE ITEMS ON THE FINANCIAL STATEMENTS

While this list is not exhaustive, it covers most of the basic interconnections across a company’s Financial Statements:

• Income Statement:
o Depreciation: Fixed Long-term Assets (Balance Sheet) are depreciated over a period of time; this is expensed on the Income
Statement.
o Amortization: Some other Long-term Assets (Balance Sheet) are amortized (similar to being depreciated) over a period of time; this is
expensed on the Income Statement.

• Balance Sheet:
o Cash: Ending Cash on the Cash Flow Statement flows into Cash within Current Assets on the Balance Sheet.
o Shareholder’s Equity: Net Income (Earnings from the Income Statement) after Dividends Paid flow into Retained Earnings in
Shareholder’s Equity.
• Cash Flow Statement:
o Beginning Cash: This is equal to the previous period’s ending Cash balance on the Company’s Balance Sheet.
o Net Income (CFO): Equals Net Income found on the Income Statement.
o Depreciation (CFO): Depreciation is a (generally unlisted) component of COGS and other expense items found on the Income
Statement; it is added back because it is a non-Cash expense. In other words, the company did not actually spend the money being
represented by Depreciation during the period—that Cash expense was recorded as a Capital Expenditure in a prior period. That value is
allocated over a long time horizon, and Depreciation in any given year represents that year’s ascribed value of the Assets being used.
o Amortization (CFO): Amortization is a (generally unlisted) component of COGS and other expense items found on the Income
Statement; like Depreciation, it is added back because it is a non-Cash expense. The Cash was generally spent in a prior period, usually
as part of an acquisition.
o Capital Expenditures (CFI): This is money spent on Long-term (Fixed) Assets on the Balance Sheet. The change in these Assets
should equal Capital Expenditures minus the year’s Depreciation on these Assets.
o Repayments of and Proceeds from Long-term Debt (CFF): This is money raised from, or used to repay, Long-term Debt
obligations (Liabilities) on the Balance Sheet. (Note that mandatory Debt repayments coming due in the near future are moved from
Long-Term Liabilities to Current Liabilities on the Balance Sheet as their repayment dates draw near.)
o Ending Cash: This is equal to the current period’s ending Cash balance on the Company’s Balance Sheet.

HOW DOES DEPRECIATION AFFECT THE FINANCIAL STATEMENTS?

Depreciation is an especially tricky line item because it affects all three Financial Statements, but is often not broken out directly in the
Income Statement even though it is an annual expense. Here is a summary of how Depreciation affects all three Statements (a similar
description also applies to Amortization):

• Income Statement: Depreciation is an expense on the Income Statement (often buried inside displayed line items such as COGS).
Increasing Depreciation will increase expenses, thereby decreasing Net Income.
• Cash Flow Statement: Because Depreciation is incorporated into Net Income, it must be added back in the SCF, because it is a non-
cash expense and therefore does not decrease Cash when it is expensed.
• Balance Sheet: Net Fixed Assets (generally Plant, Property, and Equipment) is reduced by the amount of the Depreciation. This
reduces Fixed Assets. It also reduces Net Income and therefore Retained Earnings (Shareholders’ Equity) as well. As discussed
previously, Depreciation is a non-Cash expense. Therefore, increases or decreases to Depreciation will not impact Cash directly.

YPES OF MULTIPLES

There are various types of multiples that can be used in a Comps analysis. In general, multiples can be classified in two broad
categories: Operating multiples and Equity multiples. Operating multiples refer to the operating results of the business as a whole
while Equity multiples refer to the value created from the company that is available to equity/shareholders.

Typical multiples for Comps include:

• EV/Sales: The Enterprise value of the company divided by Sales/Revenue (Operating multiple)
• EV/EBITDA: The Enterprise value of the company divided by EBITDA (Operating multiple)
• P/E: Price/Earnings ratio for a company (Equity multiple). This is either calculated as Share Price ÷ EPS, or Market Capitalization ÷
Earnings (they are mathematically equivalent).
• P/B: Price/Book ratio for a company (Equity multiple). This is either calculated as Share Price ÷ Book Value per Share, or Market
Capitalization ÷ Shareholders’ Equity (they are mathematically equivalent).
• P/(Levered) Cash Flow: Price/Cash Flow ratio for a company (Equity multiple). This is either calculated as Share Price ÷ Levered
Cash Flow per Share, or Market Capitalization ÷ Levered Cash Flow (they are mathematically equivalent).

Note that for Operating Multiples we use Enterprise Value as the numerator of the calculation, while for Equity Multiples, we use
Market Capitalization as the numerator. You should generally not use EV for equity-related performance metrics, nor should you use
Market Capitalization for enterprise-related performance metrics.

RECAP ON OPERATING MULTIPLES:

• The most commonly used Operating multiples are EV/Sales and EV/EBITDA.
• Operating multiples ignore financial leverage (Debt) and typically ignore Depreciation & Amortization.
• They value the total company versus common stock (Equity) only.
• They are frequently used by investment bankers, private equity investors.

RECAP ON EQUITY MULTIPLES:

• The most commonly used Equity multiples are P/E, P/B, and P/Cash Flow (Levered).
• Equity multiples ignore cash flow to Debt holders.
• They are frequently used by investment bankers and equity analysts.

In this training course, the two most common multiples, EV/EBITDA (an Operating multiple) and P/E (an Equity multiple), will be
used. However, it is still worthwhile to be aware of other kinds of multiples, as they are frequently used.

WHEN ARE PRICE/SALES MULTIPLES USED?

Price/Sales multiples are typically used for Companies With Negative, Highly Volatile, Or Abnormally High/Low EPS. For
example, fast-growing companies that have no earnings yet or negative earnings (because they are spending a lot of money to grow or
have not yet reached critical mass for sales) may be valued based upon multiples of Sales. A common advantage of using Price/Sales is
the general stability and lower accounting distortion afforded by sales numbers. However, sales numbers can be manipulated through
revenue recognition practices and growth companies can be given high valuations regardless of having no earnings or cash flow.
Additionally, using Sales as a basis for valuation does not take into account the profitability of those Sales figures. Some companies, for
example, may be able to turn a large profit margin on incremental sales, while others might have very narrow profit margins.

WHEN ARE PRICE/BOOK MULTIPLES USED?

Price/Book multiples are often used to value financial services companies since their balance sheets are primarily composed of liquid
assets that often approximate market values. These multiples can also be used for companies with no earnings, highly variable earnings
or companies not expected to continue as a going concern. Unfortunately, for most companies in most industries the Price/Book ratio is
highly idiosyncratic, because the Book Value is a function of all past business activities (literally since the company’s founding or most
recent recapitalization). Therefore Price/Book ratios can swing wildly depending on each company’s circumstances.
 WHAT ARE CASH FLOW MULTIPLES?

Cash Flow multiples use an estimate of Cash Flow, such as EBITDA, Operating Cash Flow, Free Cash Flow, and Levered Free Cash Flow,
as a valuation indicator. These multiples are often superior to Earnings multiples because they ignore a lot of the idiosyncrasies of
accrual-based accounting and are therefore less subject to management manipulation. (Note that EBITDA ignores Capital
Expenditures, which are indeed a Cash outflow. Thus in many instances Comps will use (EBITDA – Capital Expenditures) as the Cash
Flow estimate.)

Many times in practice, the reciprocal of these multiples are used to produce Cash Flow Yields, which are compared against treasury
yields and dividend yields as a valuation yardstick.

PITFALLS TO AVOID WHEN USING COMPS

Avoid these typical pitfalls when building a Comps analysis:

• Inappropriate peer universe selected

• One-off and recurring items included in historical/projected EBITDA and EPS
• Wrong multiple selected for valuation

Again, remember the mnemonic, “C.V.S.”

• Confirm relevant peer universe.

• Validate key fundamental metrics.
• Select appropriate multiple for valuation.

STEPS TO REMEMBER FOR EXECUTING A COMPS VALUATION

1. Select a Peer Universe: Pick a group of competitor/similar companies with comparable industries and fundamental characteristics.
2. Calculate Market Capitalization: It is equal to Share price × Number of Shares Outstanding.
3. Calculate Enterprise Value: Market Capitalization + Debt + Preferred Stock + Minority Interest (less common) – Cash.
4. Historical & Projected Financials: Use historical financials from filings and projections from management, sell-side equity
analysts, etc.
5. Spread Multiples: Using Market Capitalization, Enterprise Value and historical/projected financials, spread (i.e., calculate)
EV/EBITDA and P/E multiples.
6. Value Target Company: Pick the appropriate benchmark valuation multiple for the peer group, and value the target company based
on that multiple. Typically, an average or median is used.

ecessary financials typically include the following information:

• Market Capitalization (Stock Price × Shares Outstanding)

• Enterprise Value (Market Value + Net Debt + Preferred Stock + Minority Interest – Cash)
• Earnings per Share (EPS, Net Income ÷ Shares Outstanding)
• Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA)

Here is an example of a final output from a Comps Analysis. The key financial inputs to this analysis will then be discussed:

MARKET CAPITALIZATION (MARKET VALUE)

Market Capitalization represents the total equity value of a company, and does not reflect management’s allocation of capital structure
among all forms of financing (such as equity, debt, preferred stock, etc.). It is a useful representation of valuation for common stock
investors because they typically do not purchase a majority-owned stake in the company, and therefore only have access to the earnings
available to common shareholders.

The formula for calculating Market Capitalization is:

Market Capitalization = Stock Price × Shares Outstanding

Stock price is the price per common share. It is obtained using any financial software (Thomson, Bloomberg, CapIQ) or reliable
Internet pricing service (Yahoo Finance, Google Finance). (Be sure to verify that price is the closing price as of the analysis date.)

There are two types of Shares Outstanding: Basic and Diluted. Basic shares outstanding can be obtained from the first page of a
company’s 10-K or 10-Q. Diluted shares outstanding account for the conversion of options, warrants and convertible preferred stock
and prevents a possible underestimate of valuation caused by using basic shares outstanding. Diluted shares outstanding can be
 obtained from the EPS footnotes of a company’s financials, and can also be calculated directly using footnotes to the financials that list
management stock options as well as warrants and convertible preferred stock.

ENTERPRISE VALUE

Enterprise Value (EV) represents the total value of a company and incorporates all of the components of management’s allocation of the
capital structure–equity, debt, preferred stock, etc. It is a useful representation of valuation for strategic and private equity investors
because it represents the takeover value of the company (prior to any control premium for the acquisition).

The formula for calculating EV is:

EV = Market Capitalization + Debt + Preferred Stock + Minority Interest – Cash

Let’s look briefly at what each of these components of EV refer to and how they are calculated.

MARKET CAPITALIZATION

• Market Capitalization, as defined earlier (Stock Price × Shares Outstanding), refers to the total equity value of the company.
• It can be defined using Basic shares outstanding or Diluted shares outstanding.

DEBT

• Includes short and long-term debt, as listed on the company’s balance sheet, as well as current portions of long-term debt (listed in the
Current Liabilities section of balance sheet).
• Each line item of debt will generally be footnoted with specific terms of the debt arrangement given.

PREFERRED STOCK

• Listed in the Equity section of the balance sheet, Preferred Stock is a special tranche of the capital structure that has some debt-like
qualities (like paying interest) and some equity-like qualities (often convertible into shares, and sometimes has voting rights alongside
common equityholders).
• Only include: mandatorily redeemable and convertible preferred where conversion price > stock price.

MINORITY INTEREST (WHAT IS IT AND WHY DO WE INCLUDE IT?)

• Minority interest is the equity interest that other entities have in a division (subsidiary) of the company. This will occur whenever the
company owns more than 50% but less than 100% of the equity in a subsidiary. The company has control over the subsidiary, but
doesn’t own all of it.
• These subsidiaries will have financial results that are fully consolidated into the company’s financial results. Therefore, financial results
such as Sales, EBITDA, Earnings, etc. that are attributable to other owners will be included in the valuation metrics. The numerator of
the calculation should therefore include these minority stakes in the subsidiaries as well.
• For accounting purposes, Minority Interest is treated as a liability on the Balance Sheet and this liability amount should be added into
the EV calculation.

WHY IS CASH DEDUCTED IN THE ENTERPRISE VALUE CALCULATION?

• Cash is subtracted out of Enterprise Value because excess Cash is considered a non-operating asset, and could be used to pay down part
of the company’s debt immediately, which would reduce the Enterprise Value of the Company. (Note that the definition of “excess cash”
is somewhat loose, as it refers to cash that is not needed to conduct the operations of the business; a simplifying assumption in most
cases is to count all Cash as excess Cash.)

Historical & Projected Financials

Two fundamental metrics will always need to be calculated and input into the analysis before the Comps can be spread: 1) EPS and 2)
EBITDA. These form the denominators of the multiples used in the analysis. Each of the examples given below consist of a historical
financial result (2011 in this example) and projected (2012E & 2013E) financial result.

HISTORICAL EPS

Historical EPS can be obtained directly from a company’s income statement in the 10-K, 10-Q or most recent earnings press release.
Note, however, that Historical EPS will often need to be adjusted for non-recurring items such as one-off charges (e.g. restructuring),
extraordinary gains/losses, etc. Often, management details adjustments in company press releases. These press releases can be found in
the Investor Relations section of company website, or via footnotes or the Management Discussion & Analysis (MD&A) section of 10-K
and 10-Q filings.

These items need to be added on a pre-tax basis for “above-the-line items” (items that appear before the Taxes line item in financial
statements, such as Revenue, Gross Profit, and Operating Profit). If the adjustment is to a “below-the-line” item, use the effective tax
rate to determine the relevant pre-tax amount. For adjustments to Net Income, use the effective tax rate on all pre-tax items to
determine the appropriate after-tax amount.

PROJECTED EPS

Projected EPS can be derived in several different ways:

• Management estimates
• Consensus analyst estimates from aggregators such as Thomson One, Capital IQ or Zacks
• Individual sell-side research analysts
• Your own financial model (this is rare for an initial cut at a Comparable Companies Analysis)

EBITDA

EBITDA is calculated using the following formula:

EBITDA = EBIT (Operating Profit) + Depreciation + Amortization

Spread Multiples
The next step after collecting the relevant peer universe and locating the necessary financials for each peer is to start “spreading” the key
trading multiples—in other words, calculating and displaying them in an easy-to-read fashion, typically in a spreadsheet. This approach
allows users to easily see the valuation calculations across your custom-defined peer universe.

The Comps table should include Mean, Median, Min and Max statistics for each metric in each year to provide a valuation range for the
company you are valuing.

VALUE TARGET COMPANY

The final step, once multiples for the peer universe have been spread, is to use this information to determine valuation. With the
valuation metrics calculated as described, we can use the multiples of the peer universe to determine the valuation of the target
company.

Let’s look at an example:

COMPANY F HAS AN ESTIMATED EPS OF $1.50 IN 2012. HOW MUCH IS ITS STOCK WORTH
USING THE COMPS GIVEN?

The calculation is as follows:

• The Comps set given is trading at 12.4x (median) 2012E Earnings Per Share.
• 12.4 × $1.50 = $18.60. (P/E multiples gives us Market Value Per Share, so we are finished!)

COMPANY F HAS AN ESTIMATED EBITDA OF $77 (MILLION) IN 2012. HOW MUCH IS ITS
STOCK WORTH USING THE COMPS GIVEN?

The calculation is as follows:

• The Comps set given is trading at 5.4x (median) 2012E EBITDA.

• 5.4 × $77 million = $415.8 million. (This is the Enterprise Value; we need to back out Net Debt to get to Market Capitalization. The
difference between the EV and Mkt. Cap. given for Company F must equal Net Debt.)
• $415.8 million – ($417 million – $422 million) = $415.8 million + $5.0 million = $420.8 million. (This is Market Capitalization; we
need to divide by Shares Outstanding to get the Share Price.)
• $420.8 million ÷ 30.2 million = $13.93.

VALUATION CONCLUSION

Based on comparable company analysis, Comp F is worth between $13.93 – $18.60 based on 2012E P/E and
EBITDA multiples of public competitors.

1. Market Capitalization Outstanding Shares x Stock Price

2. Earnings per Share (Net Income - Preferred Dividends) ÷ Average Oustanding Common Shares

3. Cash Flow per Share (Operating Cash Flow – Preferred Dividends) ÷ Common Shares Outstanding
SINCE THE NUMBER OF OUTSTANDING SHARES IS INCORPORATED INTO KEY CALCULATIONS OF
FINANCIAL METRICS SUCH AS EARNINGS PER SHARE AND BECAUSE THIS NUMBER IS SO SUBJECT TO
VARIATION OVER TIME, THE WEIGHTED AVERAGE OF OUTSTANDING SHARES IS OFTEN USED IN ITS STEAD
IN CERTAIN FORMULAE.

For example, say a company with 100,000 shares outstanding decides to perform a stock split, thus increasing the total
amount of shares outstanding to 200,000. The company later reports earnings of $200,000. To calculate earnings per
share for the overall inclusive time period, the formula would be as follows:

(Net Income - Dividends on Preferred Stock (200,000)) ÷ Outstanding Shares (100,000 - 200,000)
But it remains unclear which of the two variant outstanding share values to incorporate into the equation: 100,000 or
200,000. The former would result in an EPS of $1, while the latter would result in an EPS of $2. In order to account for
this inevitable variation, financial calculations can more accurately employ the weighted average of outstanding shares,
which is figured as follows:

(Outstanding Shares x Reporting Period A) + (Outstanding Shares x Reporting Period B)

In the above example, if the reporting periods were each half of a year, the resulting weighted average of outstanding
shares would be equal to 150,000. Thus, in revisiting the EPS calculation, $200,000 divided by the 150,000 weighted
average of outstanding shares would equal $1.33 in earnings per share.

#7 Paushak
Paushak is India’s largest phosgene-based specialty chemicals manufacturer serving pharma, agrochemical, and
performance industries.
It’s part of the Alembic group of companies situated in Gujarat, India. Alembic is the oldest pharma company in India
founded in 1907.
It’s among the smallest companies to receive the permission to use the “Responsible Care" logo (RC) from Indian
Chemical Council (ICC). Other companies which have this permission in India are big players or MNCs.
Coming to the low equity, Paushak has a total of 3.1 m shares outstanding as on June 2021. From this, promoters hold
around 2.1 m shares, or 66.97% stake.
This leaves its public shareholding with only 1 m shares.
Renowned investor Ashish Kacholia holds 1.3% stake or 39,497 shares in the company. Recently in June, he purchased
an additional 17,461 shares of the specialty chemicals company.