In How to Get an Investment Banking Job, we discussed how a career in investment banking is different to other industries. Even when interviewing for an investment banking analyst role, a candidate is expected to know everything about the industry including the technical stuff related to company valuation and financial modelling. The most commonly used business valuation methods are:
Trading comparables, which is the focus of this article is a relative valuation methodology based on current market prices of publicly traded peers
Transaction comparables, a valuation methodology based on precedent transactions that determines how much an acquirer has paid for a target
Discounted Cash Flow or DCF, gives intrinsic value of a firm and involves forecasting free cash flows a business is expected to generate in the future and discounting these to present terms using a discount rate.
1. BREAD & BUTTER
Trading comparables are a bread and butter skill set for all aspiring investment banking analysts and associates. If you’re covering the telecom sector in Europe, then you’ll be tracking Vodafone, Deutsche Telekom, France Telecom, Telefonica, British Telecom and the likes very closely. Tracking means more than just updating numbers once a quarter when companies issue results and equity research analysts update their financial estimates. Tracking happens every minute, in this case it is more akin to stalking.
A company may raise debt or equity, announce a share buyback, announce a dividend. All these actions impact it’s financials and by extension, valuation. Likewise, if a company announces an acquisition, it is your job as an analyst to ensure that trading comparables are updated and reflect the current state of affairs. As companies go through changes, it is imperative to ensure that trading comparables capture this. It would be a mistake to think that updating trading multiples is a once a quarter affair.
2. YOUR OWN GOODWILL
As a new investment banking analyst, you have to do a great deal of own brand building in order to be accepted by your team members and win their trust. The only way to achieve this is by producing quality work time after time, consistently. Sucking up can only get you so far.
Junior analysts spend a substantial percentage of their time spreading comps and it is crucial that you get it right. If there are mistakes in your work and your team members are unable to develop confidence in your analysis, then the road ahead gets difficult. If you are unable to do the simple things well, how do you expect your team to trust you with a live deal? Get the drift? Do the simple things well. Check and re-check your work so that every time a team member gets something back from you, they know that the analysis will be spot on. That is the kind of reputation and brand that you should strive to create for yourself. It centres around an exceptional amount of hard work, diligence and attention to detail. Do this for yourself and you will never ever have to look back.
3. TRADING MULTIPLES
We will now go over the main concepts related to trading multiples so that when your interviewer asks “tell me about the main valuation methods” or “Walk me through trading comps”, you can hit the nail on the head.
Trading comps are a multiples based valuation methodology. Multiples for a particular company are calculated, then compared to industry peers in order to determine whether the stock is over valued or under valued. Therefore, this is a relative valuation methodology.
Valuation multiples reflect either equity or enterprise value. Equity multiples express the value of shareholders’ claim on the business, relative to a statistic that applies only to shareholders e.g. Earnings or Book value. Enterprise value or EV multiples express the value of the enterprise, relative to a statistic that relates to the entire enterprise such as Revenue, EBITDA, EBIT etc.
As a general rule, any profit or earnings estimates that is after interest belongs to shareholders and is therefore used to calculate equity multiples. Any metric that is before interest belongs to the firm or enterprise as a whole i.e. both debt and equity investors, and is used to calculate enterprise value or EV multiples.
Market Cap = Share Price x Fully Diluted Shares Outstanding
Unlike shareholders’ equity which is based on historical performance, market cap factors in the perceived value of goodwill, brand equity, quality of management, employees, client relationships, macro economics, competition and very importantly, the present value of future cash flows. It is due to these factors that the market value or share price can be significantly higher than book value or book value per share.
PRICE EARNINGS (PE)
The price earnings or PE multiple is by far the most popular equity value multiple that is used by Wall Street analysts and commentators alike. There are two ways that the PE multiple can be calculated. In the first method, market cap is divided by net income or earnings. The second method involves a simple division of the share price by the earnings per share or EPS. Whilst the 2 approaches are very similar, they give slightly different results. This is because, fully diluted shares outstanding are used to compute market cap under the first method. The second method uses EPS which is calculated using weighted average shares outstanding.
Though PE multiples are very widely used and are extremely popular, they have some limitations as well.
- PE multiples are based on accounting profits which can be easily manipulated. Earnings are impacted by differences in accounting policies related to depreciation
- Earnings are also impacted by capital structure i.e how a business is funded, which distorts the true picture
PRICE OVER BOOK
Another popular equity multiple is price over book value, where price is the market cap and book value is shareholders’ equity. If price over book for a company is less than 1, it may be considered to be a good buy as investors are able to own shares at less than liquidation value. Having said that, a price to book of less than 1 can also imply that all is not well at the company. This multiple is widely used for banking and financial institutions. In the aftermath of the 2008 financial crisis, price to book for most banks in the US was less than 1, as the market had lost confidence in the sector and this sentiment was reflected in their share price.
ENTERPRISE VALUE (EV) MULTIPLES
Equity value measures the value of a company attributable to share holders. But a company may also have debt investors, bondholders or other debt providers. Debt is an important component of the overall capital structure.
EV = Market Cap + Net Debt
Enterprise value or EV represents the value of a company from the persepctive of all capital providers and is calculated by adding market cap and net debt, where net debt equals all interest bearing debt minus cash and cash equivalents.
Think of EV as the theoratical takeover price of the company. When a company is being taken over, the acquiror has to compensate the target’s shareholders and either assume or pay down any debt on the target’s balance sheet. That is why, equity value and debt are added to get EV. In the same vein, the buyer has access to any cash or cash equivalents available on the target’s balance sheet which reduces the overall cost of acquisition. That is why cash and cash equivalents are subtracted while calculating EV.
EV/Revenue is a good multiple for valuing start-ups, as they tend to have operating losses in the initial years and their EBIT, EBITDA or earnings are likely to be negative. The flip side of using revenue multiples is that revenue in itself does not give any indication of profitability.
EV/EBITDA is the most popular EV multiple and is widely used for valuing companies across sectors. EBITDA stands for Earnings before Interest Tax Depreciation and Amortization. Though the EBITDA multiple is very popular for capital intensive businesses, it finds widespread application across a range of industries since it is capital structure neutral and not impacted by differences in accounting policies related to depreciation & amortization.
EV/ EBIT multiple is useful for less capital intensive industries where the d&a burden is likely to be less significant.
ADJUSTING ENTERPRISE VALUE (EV)
EV = Market Cap + Net Debt
Denoting EV as the sum of market cap and net debt is a good starting point, surely. But this is a fairly basic representation of EV and certain adjustments need to be made in order to calculate multiples that are both accurate and capture reality.
A company’s share price is proportionate and reflects all publicly available information. This includes the ownership stakes that a company may be having in other subsidiaries, associates and affiliates. Calculating multiples accurately is about comparing like with like. Multiples will only work if the both the numerator and denominator are consistent i.e either consolidated or proportionate.
THE PROBLEM – EV / EBITDA
The task at hand is to calculate the EV/ EBITDA multiple for company A, which is the parent and has a 70% stake in company B, the subsidiary. Company A uses line by line consolidation and takes into account a 100% of company B’s revenues, expenses, assets, liabilities etc when preparing it’s group accounts, even though it owns only 70%. Market cap for Company A can be calculated by multiplying it’s share price with fully diluted shares outstanding. EV can be obtained by adding net debt to market cap. Since share price is proportionate, Company A’s share price reflects a 70% ownership in Company B. At this stage, EV for Company A, reflects a 70% ownership in Company B. So this is the picture as far as the numerator is concerned.
What is going on with the denominator, which is EBITDA. The parent company consolidates its subsidiaries, which means that its EBITDA reflects a 100% of Company B’s EBITDA, even though it owns only 70%. At this stage, would a simple division of EV and EBITDA yield the correct multiple? Clearly there is a problem at the moment since the numerator reflects a proportionate EV which captures 70% of Company B’s value. But the denominator reflects a consolidated EBITDA which takes into account a 100% of Company B’s EBITDA. What is the solution then?
THE FIX – NON CONTROLLING INTEREST
Since EV currently reflects only 70% of Company B, value of the remaining 30% stake that is not owned by Company A must be added to EV. This value is known as non controlling interest or NCI and can be found on the balance sheet of the parent company. When this is done, both the EV and EBITDA reflect a 100% of Company B and there is consistency between numerator and denominator. Therefore, in cases where subsidiaries which are not a 100% owned by the parent company are consolidated, certain adjustments need to be made to EV. This is done by adding the value of non controlling interest or NCI to EV.
ASSOCIATES & AFFILIATES
Using similar logic, value of associates and affiliates are subtracted from EV in order to arrive at adjusted EV.
EV = Market Cap + Net Debt + Non Controlling Interest – Investment in Associates – Investment in Affiliates
ABOUT THE AUTHOR
Founded in 2007, by a former banker from Lehman Brothers, School of Investment Banking is a unique and one of a kind Investment Banking training institute. What sets us apart is the fact that we leverage our deep contacts with recruiters to secure world class placement opportunities for candidates. That’s why SIB alumni are pursuing their career ambitions as Investment Banking Analysts with major recruiters such as JP Morgan, Goldman Sachs, Citi, Deutsche Bank, Bank of America, HSBC, Nomura, PwC, Ernst & Young, KPMG, Deloitte and Grant Thornton among others across the world. With an average placement record of 90% since inception, we know more than a thing or two about getting your foot in the door!
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