INTRODUCTION TO

INVESTMENT BANKING

UNIT-1
INVESTMENT BANKING
(DEFINITION)
Investment Banking is the business of providing financial
services for corporate and institutional customers, such as
investing and raising capital and
arranging mergers and acquisitions.
Investment bankers raise money from investors by
selling securities, and then transferring that money to
people who need cash to start business, build buildings,
run cities or bring other costlier project to reality.
THE ROLE INVESTMENT
BANKING PLAYS
Investment bankers get involved in the very early stages of
funding a new project . Investment bankers are typically
Contracted by people, companies, or governments who need cash
to start business , expand factories, and build school and bridges.
There are generally following roles of investment bankers-;
1. capital raising. 2. financial advisory
3. corporate lending 4. sales and trading
5. brokerage services 6. research.
7. Investment
 THE SERVICE INVESTMENT
BANKS PROVIDE
Investment banks do much more than just raise capital by selling investments.
Although selling securities to raise money is the primary function of the
investment banks, they also serve several other roles. All the function of
investment banks typically fall into one of two primary categories: selling or
buying
The sell side -: investment banks are well known for the part of their business that sell
securities or the sell side. This function of investment bank responsible for finding
investors to buy the securities being sold out, which raise the money needed by
businesses and government to grow and prosper.
The buy side-: investment bank also take the role of advising the large investors who
are interested in buying financial instrument. Serving in its role on the buy side , the
investment bank can offer suggestions to large institutional investors like mutual
funds, pension plan, or any other investment to buy in order to meet return target .
HOW INVESTMENT BANKS
ARE ORGANIZED
All major investment banks divide their operation into several key area, including
the front office, middle office and back office.
The front office-: from the front office investment banks helps in M&A process by
pairing up buyers and sellers. The front office also part of the investment bank that
conducts trading. Investment bank used to do some trading using complicated
mathematical formula and using firm money. This types of trading is often called
proprietary trading. Such types of trading was quite profitable for investment banks.
But such trading were abolished in mid-2015 by the Volcker rule. The rule is named
after former federal reserve board chairman Paul Volcker.
Another part of front office is the part of business involved in conducting research
on companies. The front office often employee sell side analyst. Whose job is to
closely monitor companies and industries and produce report used by large investors
trying to decide whether to buy or sell particular securities.
HOW INVESTMENT BANKS
ARE ORGANIZED
Then Middle office: the middle office of an investment bank is generally
out of the limelight. It is that part of the bank with the job of cooking up
new types of securities that can be sold to investors. Some innovation
in investment banking are useful, but other can wind up putting
investors and the markets in general in an unfavorable light. Some of
the infamous financial instruments cooked up in the middle office of
investment banks that came back to haunt the system include auction-
rate securities and credit default swaps.
Auction-rate securities are debt instruments that promise investors
higher rates of return than are available in savings accounts. Instead of
selling debt at prearranged interest rate, the investment bank would
conduct auctions, and the rate would be set by a bidding process.
Credit default swaps are tools that allow lenders to sell the risk that
borrowers won ’ t be able to meet their obligations. Credit default
swaps operate as a form of unregulated insurance policies.
HOW INVESTMENT BANKS
ARE ORGANIZED
The back office is the part of the investment bank that is far from the glamour
of the front office. It ’ s primarily made up of the systems and procedures that
allow investment bankers to gather the data they need to do their jobs well.
The back office, for instance, maintains the computer systems used by
investment bankers to gauge interest in certain securities and provides traders
the ability to make short-term bets on market movements. The parts of
investment banking considered more operational in nature tend to fall into the
back office.
Investment banking operations are rarely identical between firms. Some banks
and investment banks are engaged in some front-office areas, while others
steer clear of them completely. There are also some peripheral areas of
business some banks and investment banks include as part of their services
that don ’ t fall in one of the traditional “offices.” One example of a service that
is often grouped in investment banking is investment management. In an
investment
management unit, investment professionals are paid to invest money on behalf
of individual clients or institutions.
TYPES OF INVESTMENT
BANKING OPERATION
There are following types of investment banking operation-:
1. Bulge bracket-: They are big firm. They have their hands in most area of
investment banking.
2. Boutique -: These firm are smaller investment bank and tradition banks
that choose to focus on or a select few areas of the business.
3. Regional -: These firm focus on a particular part of a country. Some
regional firm also concentrate on a particular type of investment banking
services or underwriting of securities.
HOW INVESTMENT BANK
GET PAID
1. commissions.
2. Underwriting fees.
3. Trading income.
4. Asset Management fee
5. Advisory fees
HOW INVESTMENT BANKING
DONE/ROLE OF INVESTMENT
BANKERS
1. finding the financial statement.
2. understanding the importance of financial statement and ratios
3. zeroing the past transaction
4. seeing the value of fixed income.
5. putting the discounted cash flow analysis to work.
6. Analyzing how leverage becomes a force in investment banking
7. pinpointing buyout target.
8. looking beyond the published financial data
ROLE OF INVESTMENT
BANKERS IN IPO
1. providing assistance to company in preparation of prospectus.
2. arranging events and meeting between companies and
prospective investors.
3. help in book building process ( to decide price range )
4. underwriters price deal.
5. underwriter support the IPO.
BOOK BUILDING AND
VALUATION OF IPO
Book Building is the process by which an underwriter determines the price at which the shares must be
sold in an Initial Public Offer (IPO). The process of price discovery requires the underwriter to call
forth bids from various institutional investors such as fund managers and others. However, there always
exists a risk of overpricing or undervaluing the shares.
There are following steps of book building to determine value of IPO-:
1. The issuing company hires an investment bank to act as an underwriter who decides the price range
of the security.
2. The investment bank then, invites large scale buyers, fund managers and others, to submit bids on
the shares.
3. The book is then built through the listing and evaluation of the aggregated demands for
the issue from the submitted bids. The final price of the security is termed as the cut-off price.
4. The underwriter published the details of the bids in order to maintain transparency in the entire
process.
5. Shares are allocated to the accepted bidders, thereafter.
6. The prices determined in the book building process does not suggest that the price is the best price,
nor is it mandatory for the company to use the said price in an IPO.
PRIVATE EQUITY
Private equity (PE) is an investment strategy where firms or
accredited investors provide funds to companies that are not
publicly traded on a stock exchange. In a typical PE deal, an
investor buys a stake in a private company with the hope of
increasing the value of that stake.
Private equity firms use a range of strategies to acquire companies
and help them grow over time. These strategies include: Leveraged
buyouts, Venture capital, Growth capital.
PE firms make direct investments in these companies for an
extended period. Generally, private equity investments have
holding periods of a long time.
PE firms can also acquire control of public companies with plans to
take them private and delist them from stock exchanges. By doing
so, general partners can obtain control over management and
other operational changes to increase profitability.
TYPES OF PRIVATE EQUITY
FIRM
Private equity firms have a range of investment preferences. Some are strict financiers
or passive investors wholly dependent on management to grow the company
and generate returns. Because sellers typically see this as a commoditized approach,
other PE firms consider themselves active investors. That is, they provide operational
support to management to help build and grow a better company.
Active private equity firms may have an extensive contact list and C-level relationships,
such as CEOs and CFOs within a given industry, which can help increase revenue. They
might also be experts in realizing operational efficiencies and synergies. If an investor
can bring in something special to a deal that will enhance the company's value over
time, they are more likely to be viewed favorably by sellers.
Investment banks compete with some private equity PE firms, also known
as private equity funds, to buy good companies and finance nascent ones.
Unsurprisingly, the largest investment-banking entities such as Goldman Sachs (GS),
JPMorgan Chase (JPM), and Citigroup (C) often facilitate the largest deals
HEDGE FUNDS
Hedge fund is a fancy name for an investment partnership with freer rein to
invest aggressively in a wider variety of financial products than most mutual
funds. A hedge fund's purpose is to pool funds, maximize investor returns,
and eliminate risk with hedging strategies. If this structure and these
objectives sound a lot like those of mutual funds, they are, but that's where
the similarities end. Hedge funds are generally considered more aggressive,
risky, and exclusive than mutual funds.
The hedge fund industry has grown tremendously since its inception. There
are trillions of dollars of assets under management, more than 8,800 hedge
fund managers, and over 27,000 funds globally.
TYPES OF HEDGE FUND
Hedge funds target select investments and pools of securities
primed for gains. Four common types of hedge funds include:
Global macro hedge funds are actively managed funds that attempt
to profit from broad market swings caused by political or economic
events.
An equity hedge fund may be global or specific to one country,
investing in lucrative stocks while hedging against downturns in
equity markets by shorting overvalued stocks or stock indices.
A relative value hedge fund seeks to exploit temporary differences
in the prices of related securities, taking advantage of price or
spread inefficiencies.
An activist hedge fund aims to invest in businesses and take
actions that boost the stock price which may include demands that
companies cut costs, restructure assets or change the board of
VENTURE CAPITAL FIRM
Venture capital firms are investment firms that raise money from wealthy investors and invest in
startups. They also mentor startups to help them grow. Venture capital firms invest in early-stage
companies in exchange for equity, or an ownership stake. They take on the risk of financing risky
startups in the hopes that some of the companies they support will become successful.
Venture capital firms are generally made up of well-off investors, investment banks, and other
financial institutions. They raise money from limited partners (LPs) to invest in promising
startups or even larger venture funds. They also invest from their own funds to show commitment
to their clients.
Venture capital firms make money in two ways: via management fees and carries (carried
interest). Management fees are usually defined as the "cost of having your assets professionally
managed".
Some of the top venture capital firms in India include:
Accel Partners, Sequoia Capital, Blume Ventures, Kalaari Capital, Nexus Venture, Helion Venture
Partners, Chiratae Ventures, Matrix Partners.
KEY FEATURES-:
1. Venture capital is a term used to describe financing that is
provided to companies and entrepreneurs.
2. Venture capitalists can provide backing through capital financing,
technological expertise, and/or managerial experience.
3. VC can be provided at different stages of their evolution,
although it often involves early and seed round funding.
4. Venture capital funds manage pooled investments in high-growth
opportunities in startups and other early-stage firms and are
typically only open to accredited investors.
[Link] capital evolved from a niche activity at the end of the
Second World War into a sophisticated industry with multiple
players that play an important role in spurring innovation
TYPES OF VENTURE CAPITAL
Seed capital
This is the earliest stage of venture capital financing. It's the initial funding
that entrepreneurs seek when they don't have a product or organized
business.
Angel investors
These individuals invest their own money into startup companies in exchange
for equity. They usually invest smaller amounts than venture capitalists
Venture capitalists
These investors are interested in private equity investments to startups that
have a high growth ability. They may fund start-ups or support small
companies that want to expand.
Corporate venture capital
This is when established corporations invest directly into startups. This allows
the corporation to access innovative technologies, products, or talent.
CORPORATE VALUATION
ANALYSIS

UNIT-2
INVESTMENT ANALYSIS IN
CORE INVESTMENT BANKING
Investment banking requires a deep understanding of financial securities,
fundamental analysis of financial performance of companies and their
businesses, parameters used for evaluating various investment opportunities
and to ascertain the value of business for which the bankers are appointed to
conduct a transaction. In this unit we study the Following aspects of
investment analysis and corporate valuation -:
1. key performance matrix associated with equity investors.
2. Approaches to equity valuation
3. Approaches to corporate valuation
EQUITY PERFORMANCE
METRICS
Equity performance metrics is measured to the wealth creation potential for
an investors as well as the value addition from corporate perspective. There
are following concepts related with equity performance metrics-:
1. Earning per share(EPS)-:
EPS = Earning for equity/ number of shareholder
2. Return on equity ( ROE/ RONW)-: it measure return generated by company
on shareholder fund. If ROE is more than cost of equity it would mean that
the company is creating shareholder wealth. In such case company is high
growth company and should adopt a low or no dividend policy to protect
shareholder value. On the other hand if ROE less than cost of equity it means
company business is unprofitable or company is overcapitalize with equity.
ROE=PAT/Net worth
Net worth = paid-up capital + accumulated cash reserve and surplus.
EQUITY PERFORMANCE
METRICS
3. price/Earning Ratio(P/E Ratio)-: this is good measure to know market
expectation on the share. This ratio indicate the number of times of current
EPS that a market is willing to pay for the share. Therefore higher the P/E
Ratio , greater the expectation on the future potential.
P/E Ratio = CMP/EPS
4. Dividend yield-: this ratio denote how much return a shareholder makes by
buying the share from the market before the dividend payout(cum-dividend)
thereby becoming a recipients of such dividend. If cum dividend price of
share is low the dividend yield is high and vice-versa.
Dividend yield = DPS/CMP
EQUITY PERFORMANCE
METRICS
5. Dividend payout- this measure denote how much current earning are
being paid out as dividend.
Dividend payout ratio= dividend/PAT
6. Economic value added(EVA)-: The EVA is very effective measure of
shareholder value created by a company. It measure in absolute terms
the surplus generated by the operations for a given year over the
expected cost of equity and debt.
EVA= NOPAT – ( WACC* Capital Employed)
Capital employed = net worth + long term borrowings
7. Market Value added( MVA)- It measure the excess of company market
value over book value of its capital employed.
MVA= Market capitalization- capital employed
COMPARABLE COMPANIES
ANALYSIS
Comparable companies analysis (“comparable companies” or “trading
comps”) is one of the primary methodologies used for valuing a given focus
company, division, business, or collection of assets (“target”). It provides a
market benchmark against which a banker can establish valuation for a
private company or analyze the value of a public company at a given point in
time. Comparable companies has a broad range of applications, most notably
for various mergers & acquisitions (M&A) situations, initial public offerings
(IPOs), restructurings, and investment decisions.
Comparable companies analysis is designed to reflect “current” valuation
based on prevailing market conditions and sentiment. As such, in many cases
it is more relevant than intrinsic valuation analysis, such as discounted cash
flow analysis
COMPARABLE COMPANIES
ANALYSIS STEPS
There are following steps for Comparable Companies Analysis -:
Step I. Select the Universe of Comparable Companies
Step II. Locate the Necessary Financial Information
Step III. Spread Key Statistics, Ratios, and Trading Multiples
Step IV. Benchmark the Comparable Companies
Step V. Determine Valuation
STEP I . SELECT THE UNIVERSE OF COMPARABLE
COMPANIES

The selection of a universe of comparable companies for the target is the foundation
for performing trading comps. In order to identify companies with similar business
and financial characteristics, it is first necessary to gain a sound understanding of the
target. At its base, the methodology for determining comparable companies is
relatively intuitive. Companies in the same sector (or, preferably, “sub-sector”) with
similar size tend to serve as good comparable. While this can be a fairly simple
exercise for companies in certain sectors, it may prove challenging for others whose
peers are not readily apparent.
There are following point should be considered for selection of comparable
companies-:
1. Study the Target
2. Identify Key Characteristics of the Target for Comparison
Purposes(business and financial profile)
BUSINESS PROFILE
For identification of business profile followings points should be considered-:
1. Sector
2. Products and Services
3. Customers and End Markets(A company’s end markets refer to the broad
underlying markets into which it sells its products and services. For example,
a plastics manufacturer may sell into several end markets, including
automotive, construction, consumer products, medical devices, and
packaging.)
4. Distribution Channels
5. Geography
 FINANCIAL PROFILE
Key financial characteristics must also be examined both as a means of understanding
the target and identifying the best comparable companies.
1. Size(Size is typically measured in terms of market valuation (e.g., equity value and
enterprise value), as well as key financial statistics (e.g., sales, gross profit, EBITDA,
EBIT, and net income).
2. Profitability(A company’s profitability measures its ability to convert sales into
profit. Profitability ratios (“margins”) employ a measure of profit in the numerator,
such as gross profit, EBITDA, EBIT, or net income, and sales in the denominator.)
3. Growth (In assessing a company’s growth profile, historical and estimated future
growth rates for various financial statistics (e.g., sales, EBITDA, and earnings per
share (EPS)) are examined at selected intervals. For mature public companies, EPS
growth rates are typically more meaningful. For early stage or emerging companies
with little or no earnings, however, sales or EBITDA growth trends may be more
relevant.
FINANCIAL PROFILE
4. Return on Investment-:(Return on investment (ROI) measures a company’s ability to
provide earnings (or returns) to its capital providers. ROI ratios employ a measure of
profitability (e.g., EBIT, NOPAT,9 or net income) in the numerator and a measure of
capital (e.g., invested capital, shareholders’ equity, or total assets) in the denominator.
The most commonly used ROI metrics are return on invested capital (ROIC), return on
equity (ROE), and return on assets (ROA). Dividend yield, which measures the dividend
payment that a company’s shareholders receive for each share owned, is another type of
return metric.
5. Credit Profile(A company’s credit profile refers to its creditworthiness as a borrower.
It is typically measured by metrics relating to a company’s overall debt level (“leverage”)
as well as its ability to make interest payments (“coverage”), and reflects key company-
and sector-specific benefits and risks. Moody’s Investors Service (Moody’s), Standard &
Poor’s (S&P), and Fitch Ratings (Fitch) are the three primary independent credit rating
agencies that provide formal assessments of a company’s credit profile.
STEP I I . LOCATE THE NECESSARY FINANCIAL
INFORMATION
This section provides an overview of the relevant sources for locating the
necessary financial information to calculate key financial statistics, ratios,
and multiples for the selected comparable companies (see Step III). The most
common sources for public company financial data are SEC filings (such as
10-Ks, 10-Qs, and 8-Ks), as well as earnings announcements, investor
presentations, equity research reports, consensus estimates, press releases,
and selected financial information services.
In trading comps, valuation is driven on the basis of both historical
performance (e.g., LTM financial data) and expected future performance
(e.g., consensus estimates for future calendar years).
SEC FILINGS: 10-K, 10-Q, 8-K,
AND PROXY STATEMENT
As a general rule, the banker uses SEC filings to source historical financial
information for comparable companies. This financial information is used to
determine historical sales, gross profit, EBITDA, EBIT, and net income (and
EPS) on both an annual and LTM basis.
SEC filings are also the primary source such as balance sheet data, capital
expenditures (“capex”), basic shares outstanding, stock options/warrants data,
and information on non-recurring items. SEC filings can be obtained through
numerous mediums, including a company’s corporate website (typically
through an “Investor Relations” link) as well as EDGAR and other financial
information services.
10-K (ANNUAL REPORT)
The 10-K is an annual report filed with the SEC by a public registrant that
provides a comprehensive overview of the company and its prior year
performance. It is required to contain an exhaustive list of disclosure items
including, but not limited to, a detailed business description, management
discussion & analysis (MD&A), audited financial statements and
supplementary data, outstanding debt detail, basic shares outstanding, and
stock options/warrants data.
It also contains an abundance of other pertinent information about the
company and its sector, such as business segment detail, customers, end
markets, competition, insight into material opportunities (and challenges and
risks), significant recent events, and acquisitions.
10-Q (QUARTERLY REPORT)
The 10-Q is a quarterly report filed with the SEC by a public registrant that
provides an overview of the most recent quarter and year-to- date (YTD)
period.20 It is less comprehensive than the 10-K, but provides financial
statements as well as MD&A relating to the company’s financial performance
for the most recent quarter and YTD(Year to Date) period versus the prior
year periods.
The 10-Q also provides the most recent share count information and may
also contain the most recent stock options/warrants data. For detailed
financial information on a company’s final quarter of the fiscal year, the
banker refers to the 8-K containing the fourth quarter earnings press release
that usually precedes the filing of the 10-K.
8-K (CURRENT REPORT)
The 8-K, or current report, is filed by a public registrant to report the
occurrence of material corporate events or changes (“triggering event”) that
are of importance to shareholders or security holders. For the purposes of
preparing trading comps, key triggering events include, but are not limited to,
earnings announcements, entry into a definitive purchase/sale agreement,
completion of an acquisition or disposition of assets, capital markets
transactions, and Regulation FD disclosure requirements.
The corresponding 8-Ks for these events often contain important information
necessary to calculate a company’s updated financial statistics, ratios, and
trading multiples that may not be reflected in the most recent 10-K or 10-Q
(see “Adjustments for Recent Events”).
PROXY STATEMENT
A proxy statement is a document that a public company sends to its
shareholders prior to a shareholder meeting containing material information
regarding matters on which the shareholders are expected to vote. It is also
filed with the SEC on Schedule 14A.
For the purposes of spreading trading comps, the annual proxy statement
provides a basic shares outstanding count that may be more recent than that
contained in the latest 10-K or 10-Q. As previously discussed, the annual
proxy statement also typically contains a suggested peer group for
benchmarking purposes.
SUMMARY OF FINANCIAL DATA
PRIMARY
INFORMATION ITEMS
SOURCES
SOURCES

INFORMATION STATEMENT DATA

Sales
Gross Profit Most recent 10-K, 10-Q, 8-K, Press
EBITDA(a) Most recent 10-K, 10-Q, 8-K, Release
Press Release
EBIT
Net Income / EPS
BALANCE SHEET DATA
Cash Balance
Debt Balances Most recent 10-K, 10-Q, Most recent 10-K, 10-Q, 8-K, Press
8-K, Press Release Release
Shareholders’ Equity
Cash Flow Statement Data Most recent 10-K, 10-Q, 8-K, Press
Release

Share Data 10-K, 10-Q, or Proxy Statement,

STEP I I I . SPREAD KEY STATISTICS, RATIOS,
AND
TRADING MULTIPLES
Calculation of Key Financial Statistics and Ratios-:
Size (Market Valuation: equity value and enterprise value; and Key Financial
Data: sales, gross profit, EBITDA, EBIT, and net income)
Profitability (gross profit, EBITDA, EBIT, and net income margins)
Growth Profile (historical and estimated growth rates)
Return on Investment (ROIC, ROE, ROA, and dividend yield)
Credit Profile (leverage ratios, coverage ratios, and credit ratings)
SIZE: MARKET VALUATION
Equity Value Equity value (“market capitalization”) is the value represented by a
given company’s basic shares outstanding plus “in-the-money” stock options, war-
rants, and convertible securities—collectively, “fully diluted shares outstanding.” It
is calculated by multiplying a company’s current share price by its fully diluted
shares outstanding
EQUITY VALUE = Share price * fully diluted share outstanding
Fully diluted share outstanding = basic share outstanding + in the money option and
warrant + in the money convertible securities .
When compared to other companies, equity value only provides a measure of
relative size. Therefore, for insight on absolute and relative market performance—
which is informative for interpreting multiples and framing valuation—the banker
looks at the company’s current share price as a percentage of its 52-week high.
DISCOUNTED CASH FLOW
ANALYSIS
Discounted cash flow analysis (“DCF analysis” or the “DCF”) is a
fundamental valuation methodology broadly used by investment bankers,
corporate officers, university professors, investors, and other finance
professionals. It is premised on the principle that the value of a company,
division, business, or collection of assets (“target”) can be derived from the
present value of its projected free cash flow (FCF)
A company’s projected FCF is derived from a variety of assumptions and
judgments about its expected financial performance, including sales growth
rates, profit margins, capital expenditures, and net working capital (NWC)
requirements. The DCF has a wide range of applications, including valuation
for various M&A situations, IPOs, restructurings, and investment decisions.
DISCOUNTED CASH FLOW
ANALYSIS STEPS
Step I. Study the Target and Determine Key Performance Drivers
Step II. Project Free Cash Flow
Step III. Calculate Weighted Average Cost of Capital
Step IV. Determine Terminal Value
Step V. Calculate Present Value and Determine Valuation
STEP I . STUDY THE TARGET
AND DETERMINE KEY
PERFORMANCE DRIVERS
Study the Target-: The first step in performing a DCF, as with any valuation exercise, is to
study and learn as much as possible about the target and its sector. A thorough understanding
of the target’s business model, financial profile, value proposition for customers, end
markets, competitors, and key risks is essential for developing a framework for valuation.
The banker needs to be able to craft (or support) a realistic set of financial projections, as
well as WACC and terminal value assumptions, for the target. Performing this task is
invariably easier when valuing a public company as opposed to a private company due to the
availability of information.
Determine Key Performance Drivers-:
The next level of analysis involves determining the key drivers of a company’s performance
(particularly sales growth, profitability, and FCF generation) with the goal of crafting (or
supporting) a defensible set of FCF projections. These drivers can be both internal (such as
opening new facilities/stores, developing new products, securing new customer contracts,
and improving operational and/or working capital efficiency) as well as external (such as
acquisitions, end market trends, consumer buying patterns, macroeconomic factors, or even
legislative/regulatory changes).
STEP I I . PROJECT FREE
CASH FLOW
After studying the target and determining key performance drivers, the banker is prepared to
project its FCF. FCF is the cash generated by a company after paying all cash operating
expenses and associated taxes, as well as the funding of capex and working capital, but prior
to the payment of any interest expense . FCF is independent of capital structure as it
represents the
cash available to all capital providers (both debt and equity holders).
Free Cash Flow Calculation
Earnings Before Interest and Taxes
Less: Taxes (at the Marginal Tax Rate)
Earnings Before Interest After Taxes
Plus: Depreciation & Amortization
Less: Capital Expenditures
Less: Increase/(Decrease) in Net Working Capital
Free Cash Flow
CONSIDERATIONS FOR
PROJECTING FREE CASH FLOW
Following factors should considered for projecting free cash flow-:
1. Historical Performance
2. Projection Period Length
3. Alternative Cases
4. Projecting Financial Performance without Management Guidance
5. Projection of Sales, EBITDA, and EBIT
6. COGS and SG&A Projections.
7. EBITDA and EBIT Projections
STEP I I I . CALCULATE WEIGHTED AVERAGE
COST OF CAPITAL
WACC is a broadly accepted standard for use as the discount rate
to calculate the present value of a company’s projected FCF and
terminal value. It represents the weighted average of the required
return on the invested capital (customarily debt and equity) in a
given company. As debt and equity components have different risk
profiles and tax ramifications, WACC is dependent on a company’s
“target” capital structure.
Steps for Calculating WACC
Step III(a): Determine Target Capital Structure
Step III(b): Estimate Cost of Debt
Step III(c): Estimate Cost of Equity
Step III(d): Calculate WACC
ESTIMATE COST OF EQUITY
(RE )
Cost of equity is the required annual rate of return that a company’s equity investors
expect to receive (including dividends). Unlike the cost of debt, which can be deduced
from a company’s outstanding maturities, a company’s cost of equity is not readily
observable in the market. To calculate the expected return on a company’s equity, the
banker typically employs a formula known as the capital asset pricing model (CAPM)
Capital Asset Pricing Model CAPM is based on the premise that equity investors need
to be compensated for their assumption of systematic risk in the form of a risk
premium, or the amount of market return in excess of a stated risk-free rate. Systematic
risk is the risk related to the overall market, which is also known as non- diversifiable
risk. A company’s level of systematic risk depends on the covariance of its share price
with movements in the overall market, as measured by its beta
Calculation of CAPM
Cost of Equity (re) = Risk-Free Rate + Levered Beta x Market Risk Premium
STEP IV. DETERMINE
TERMINAL VALUE
The DCF approach to valuation is based on determining the present value of all future
FCF produced by a company. As it is infeasible to project a company’s FCF indefinitely,
the banker uses a terminal value to capture the value of the company beyond the projection
period. As its name suggests, terminal value is typically calculated on the basis of the
company’s FCF (or a proxy such as EBITDA) in the final year of the projection period.
The terminal value typically accounts for a substantial portion of a company’s value in a
DCF, sometimes as much as three-quarters or more. Therefore, it is important that the
company’s terminal year financial data represents a steady state level of financial
performance, as opposed to a cyclical high or low. Similarly, the underlying assumptions
for calculating the terminal value must be carefully examined and sensitized.
There are two widely accepted methods used to calculate a company’s terminal value—the
exit multiple method and the perpetuity growth method. Depending on the situation and
company being valued, the banker may use one or both methods, with each serving as a
check on the other.
EXIT MULTIPLE METHOD
The EMM calculates the remaining value of a company’s FCF produced after the projection
period on the basis of a multiple of its terminal year EBITDA (or EBIT). This multiple is
typically based on the current LTM trading multiples for com- parable companies. As current
multiples may be affected by sector or economic cycles, it is important to use both a
normalized trading multiple and EBITDA. The use of a peak or trough multiple and/or an un-
normalized EBITDA level can produce a skewed result. This is especially important for
companies in cyclical industries.
As the exit multiple is a critical driver of terminal value, and hence overall value in a DCF,
the banker subjects it to sensitivity analysis. For example, if the selected exit multiple range
based on comparable companies is 6.5x to 7.5x, a common approach would be to create a
valuation output table premised on exit multiples of 6.0x, 6.5x, 7.0x, 7.5x, and 8.0x
Exit Multiple Method
Terminal Value = EBITDAn x Exit Multiple
n=terminal year of the projection period
PERPETUITY GROWTH
METHOD
The PGM calculates terminal value by treating a company’s terminal year FCF as a perpetuity
growing at an assumed rate. As the formula in Exhibit 3.21 indicates, this method relies on the
WACC calculation performed in Step III and requires the banker to make an assumption regarding
the company’s long-term, sustainable growth rate (“perpetuity growth rate”). The perpetuity growth
rate is typically chosen on the basis of the company’s expected long-term industry growth rate,
which generally tends to be within a range of 2% to 4% (i.e., nominal GDP growth). As with the
exit multiple, the perpetuity growth rate is also sensitized to produce a valuation range.
Perpetuity Growth Method-:
Terminal Value = FCFn x (1 + g)/r-g
FCF=unlevered free cash flow
n=terminal year of the projection period
g=perpetuity growth rate
r=WACC
STEP V. CALCULATE
PRESENT VALUE AND
DETERMINE VALUATION
Calculate Present Value
Calculating present value centers on the notion that a dollar today is worth more than
a dollar tomorrow, a concept known as the time value of money. This is due to the
fact that a dollar earns money through investments (capital appreciation) and/or
interest (e.g., in a money market account). In a DCF, a company’s projected FCF and
terminal value are discounted to the present at the company’s WACC in accordance
with the time value of money.
Present Value Calculation Using a Year-End Discount Factor
PV of FCF = FCF x Discount Factor
DETERMINE VALUATION
Calculate Enterprise Value A company’s projected FCF and terminal value are each discounted
to the present and summed to provide an enterprise value.
Enterprise Value = discounted FCF for all year+ discounted value of terminal value
Derive Implied Equity Value-: To derive implied equity value, the company’s net debt,
preferred stock, and non controlling interest are subtracted from the calculated enterprise value.
Implied Equity Value = Enterprise Value – Net Debt + Preferred Stock + Non controlling
Interest
Derive Implied Share Price -:For publicly traded companies, implied equity value
is divided by the company’s fully diluted shares outstanding to calculate an implied
share price
Implied Share Price = Implied Equity Value /Fully Diluted Shares Outstanding
PERFORM SENSITIVITY
ANALYSIS
The DCF incorporates numerous assumptions, each of which can have a sizeable
impact on valuation. As a result, the DCF output is viewed in terms of a valuation
range based on a series of key input assumptions, rather than as a single value. The
exercise of deriving a valuation range by varying key inputs is called sensitivity
analysis.
Sensitivity analysis is a testament to the notion that valuation is as much an art as a
science. Key valuation drivers such as WACC, exit multiple, and perpetuity growth
rate are the most commonly sensitized inputs in a DCF. The banker may also
perform additional sensitivity analysis on key financial performance drivers, such as
sales growth rates and profit margins (e.g., EBITDA or EBIT).
KEY PROS AND CONS
Pros
Cash flow-based – reflects value of projected FCF, which represents a
more fundamental approach to valuation than using multiples-based
methodologies
Market independent – more insulated from market aberrations such as
bubbles and distressed periods
Self-sufficient – does not rely entirely upon truly comparable companies
or trans- actions, which may or may not exist, to frame valuation; a DCF is
particularly important when there are limited or no “pure play” public
comparable to the company being valued
Flexibility – allows the banker to run multiple financial performance
scenarios, including improving or declining growth rates, margins, capex
requirements, and working capital efficiency
KEY PROS AND CONS
Cons
Dependence on financial projections – accurate forecasting of financial
performance is challenging, especially as the projection period lengthens
Sensitivity to assumptions – relatively small changes in key assumptions, such as
growth rates, margins, WACC, or exit multiple, can produce meaningfully different
valuation ranges
Terminal value – the present value of the terminal value can represent as much as
three-quarters or more of the DCF valuation, which decreases the relevance of the
projection period’s annual FCF
Assumes constant capital structure – basic DCF does not provide flexibility to
change the company’s capital structure over the projection period